2 more chapter for previous assignment.

Do not respond to this homework. it is already assigned to someone else . it is just attachment for the assignment that I forgot to attach.

Chapter 5 and 6 for second assignment!

Thanks

part 3 Cross-Border Trade and Investment

L
E

N
IN

J
E

IV
E

After you have read this chapter you should be able to:

1
Understand why nations trade with each other.

2
Summarize the different theories explaining trade flows between

nations.

3
Recognize why many economists believe that unrestricted free trade

between nations will raise the economic welfare of countries that

participate in a free trade system.

4
Explain the arguments of those who maintain that government can play

a proactive role in promoting national competitive advantage in certain

industries.

Understand the important implications that international trade theory holds for

business practice.

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opening case

B
angladesh, one of the world’s poorest countries, has long depended heavily upon exports
of textile products to generate income, employment, and economic growth. Most of these
exports are low-cost finished garments sold to Western mass-market retailers, such as

Walmart. For decades, Bangladesh was able to take advantage of a quota system for textile
exports that gave it, and other poor countries, preferential access to rich markets such as the
United States and the European Union. On January 1, 2005, however, that system was scrapped
in favor of one that was based on free trade principles. From that point on, exporters in
Bangladesh would have to compete for business against producers from other nations such as
China and Indonesia. Many analysts predicted the quick collapse of Bangladesh’s textile
industry. They predicted a sharp jump in unemployment, a decline in the country’s balance of
payments accounts, and a negative impact upon economic growth.
The collapse didn’t happen. On the contrary, Bangladesh’s exports of textiles continued to
grow, even as the rest of the world plunged into an economic crisis in 2008. Bangladesh’s
exports of garments rose to $10.7 billion in 2008, up from $9.3 billion in 2007 and $8.9 billion
in 2006. Apparently, Bangladesh has a comparative advantage in the production of textiles—
it is one of the world’s low-cost producers—and this is allowing the country to grow its
share of world markets. Indeed, as a deep economic recession took hold in developed
nations during 2008–09, big importers such as Walmart increased their purchases of
inexpensive garments from Bangladesh to better serve their customers, who were
looking for low prices. Obviously this benefits producers in Bangladesh, but it also
benefits consumers in developed nations who can use money saved on garment
purchases to buy other goods and services.
Bangladesh’s advantage is based on a number of factors. First, labor costs
are low, in part due to low hourly wage rates, and in part due to textile
manufacturers’ investments in productivity-boosting technology during the
previous decade. Today, wage rates in Bangladesh’s textile industry are

Bangladesh’s Textile Trade

International Trade Theory

5 c h a p t e r

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162 Part Three Cross-Border Trade and Investment

about $40 to $50 a month, barely half the minimum wage in China. While
this pay rate seems dismally low by Western standards, in a country where
the gross national income per capita is only $470 a year, the textile industry
provides a living wage and a source of employment for some 2.5 million
people, 85 percent of whom are women with few alternative employment
opportunities.
Another source of advantage for Bangladesh is that it has a vibrant
network of supporting industries that supply inputs to its garment manufac-
turers. Some three-quarters of all inputs are made locally. This saves gar-
ment manufacturers transport and storage costs, import duties, and the long
lead times that come with the imported woven fabrics used to make shirts
and trousers. In other words, the local supporting industries help to boost
the productivity of Bangladesh’s garment manufacturers, giving them a cost
advantage that goes beyond low wage rates.
A third advantage for Bangladesh is that it is not China! Many importers in
the West have grown cautious about becoming too dependent upon China
for imports of specific goods for fear that a disruption, economic or other,
would decimate their supply chains unless they had an alternative source.
Thus, Bangladesh has benefitted from the trend by Western importers to
diversify their supply sources. •
Source: K. Bradsher, “Jobs Vanish as Exports Fall in Asia,” The New York Times, January 22, 2009, p. B1;
“Knitting Pretty,” The Economist, July 18, 2008, p. 54; and K. Bradsher, “Competition Means Learning to Offer
More Than Just Low Wages,” The New York Times, December 14, 2004, p. C1.

Introduction
The growth of the garment industry in Bangladesh is a striking example of the bene-
fits of free trade and globalization. Low barriers to trade have enabled Bangladesh to
exploit its comparative advantage in the production of garments and enabled the
country to grow its exports, even during a global economic downturn. This benefits
Bangladesh, one of the world’s poorest nations, whose strong garment exports help
support 2.5 million jobs and may help the country to attain sustainable economic
growth. It also benefits consumers in developed nations, who can save on their gar-
ment purchases and, as a consequence, have more money available for spending on
other goods and services, thereby helping to improve their living standards. The losers
in this process are higher-cost garment producers in more developed nations, who
have lost business to enterprises from Bangladesh.
In the world of international trade, there are always winners and losers, but as
economists have long argued, the benefits to the winners outweigh the costs born by
the losers, resulting in a net gain to society. Economists argue that in the long-run,
free trade stimulates economic growth and raises living standards across the board.
The economic arguments surrounding the benefits and costs of free trade in goods
and services are not abstract academic ones. International trade theory has shaped the

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Chapter Five International Trade Theory 163

economic policy of many nations for the past 50 years. It was the driver behind the
formation of the World Trade Organization and regional trade blocs such as the
European Union and the North American Free Trade Agreement (NAFTA). The 1990s,
in particular, saw a global move toward greater free trade. Therefore, it is crucially
important to understand these theories and why they have been so successful in shap-
ing the economic policy of so many nations and the competitive environment in
which international businesses compete.
This chapter has two goals that go to the heart of the debate over the benefits and
costs of free trade. The first is to review a number of theories that explain why it is
beneficial for a country to engage in international trade. The second goal is to explain
the pattern of international trade that we observe in the world economy. With regard
to the pattern of trade, we will be primarily concerned with explaining the pattern of
exports and imports of goods and services between countries. The pattern of foreign
direct investment between countries is discussed in Chapter 7.

An Overview of Trade Theory
We open this chapter with a discussion of mercantilism. Propagated in the sixteenth
and seventeenth centuries, mercantilism advocated that countries should simultaneously
encourage exports and discourage imports. Although mercantilism is an old and
largely discredited doctrine, its echoes remain in modern political debate and in the
trade policies of many countries. Next, we will look at Adam Smith’s theory of absolute
advantage. Proposed in 1776, Smith’s theory was the first to explain why unrestricted
free trade is beneficial to a country. Free trade refers to a situation where a govern-
ment does not attempt to influence through quotas or duties what its citizens can buy
from another country, or what they can produce and sell to another country. Smith
argued that the invisible hand of the market mechanism, rather than government pol-
icy, should determine what a country imports and what it exports. His arguments im-
ply that such a laissez-faire stance toward trade was in the best interests of a country.
Building on Smith’s work are two additional theories that we shall review. One is the
theory of comparative advantage, advanced by the nineteenth century English econo-
mist David Ricardo. This theory is the intellectual basis of the modern argument for
unrestricted free trade. In the twentieth century, Ricardo’s work was refined by two
Swedish economists, Eli Heckscher and Bertil Ohlin, whose theory is known as the
Heckscher-Ohlin theory.

THE BENEFITS OF TRADE The great strength of the theories of Smith,
Ricardo, and Heckscher-Ohlin is that they identify with precision the specific bene-
fits of international trade. Common sense suggests that some international trade
is beneficial. For example, nobody would suggest that Iceland should grow its own
oranges. Iceland can benefit from trade by exchanging some of the products that it can
produce at a low cost (fish) for some products that it cannot produce at all (oranges).
Thus, by engaging in international trade, Icelanders are able to add oranges to their
diet of fish.
The theories of Smith, Ricardo, and Heckscher-Ohlin go beyond this common-
sense notion, however, to show why it is beneficial for a country to engage in in-
ternational trade even for products it is able to produce for itself. This is a difficult
concept for people to grasp. For example, many people in the United States be-
lieve that American consumers should buy products made in the United States by
American companies whenever possible to help save American jobs from foreign
competition. The same kind of nationalistic sentiments can be observed in many
other countries.

LEARNING OBJECTIVE 1
Understand why nations

trade with each other.

Free Trade
The absence of
government barriers to
the free flow of goods
and services between
countries.

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164 Part Three Cross-Border Trade and Investment

However, the theories of Smith, Ricardo, and
Heckscher-Ohlin tell us that a country’s economy
may gain if its citizens buy certain products from
other nations that could be produced at home.
The gains arise because international trade allows
a country to specialize in the manufacture and ex-
port of products that can be produced most effi-
ciently in that country, while importing products
that can be produced more efficiently in other
countries. Thus, it may make sense for the United
States to specialize in the production and export
of commercial jet aircraft, since the efficient pro-
duction of commercial jet aircraft requires re-
sources that are abundant in the United States,
such as a highly skilled labor force and cutting-
edge technological know-how. On the other
hand, it may make sense for the United States to
import textiles from China since the efficient
production of textiles requires a relatively cheap
labor force—and cheap labor is not abundant in
the United States.

Of course, this economic argument is often difficult for segments of a country’s
population to accept. With their future threatened by imports, U.S. textile companies
and their employees have tried hard to persuade the government to limit the importa-
tion of textiles by demanding quotas and tariffs. Although such import controls may
benefit particular groups, such as textile businesses and their employees, the theories
of Smith, Ricardo, and Heckscher-Ohlin suggest that the economy as a whole is hurt
by such action. Limits on imports are often in the interests of domestic producers, but
not domestic consumers.

THE PATTERN OF INTERNATIONAL TRADE The theories of Smith,
Ricardo, and Heckscher-Ohlin help to explain the pattern of international trade that
we observe in the world economy. Some aspects of the pattern are easy to understand.
Climate and natural resource endowments explain why Ghana exports cocoa, Brazil
exports coffee, Saudi Arabia exports oil, and China exports crawfish. However, much
of the observed pattern of international trade is more difficult to explain. For exam-
ple, why does Japan export automobiles, consumer electronics, and machine tools?
Why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why
does Bangladesh export garments? David Ricardo’s theory of comparative advantage
offers an explanation in terms of international differences in labor productivity. The
more sophisticated Heckscher-Ohlin theory emphasizes the interplay between the
proportions in which the factors of production (such as land, labor, and capital) are avail-
able in different countries and the proportions in which they are needed for produc-
ing particular goods. This explanation rests on the assumption that countries have
varying endowments of the various factors of production. Tests of this theory, how-
ever, suggest that it is a less powerful explanation of real-world trade patterns than
once thought.
One early response to the failure of the Heckscher-Ohlin theory to explain the
observed pattern of international trade was the product life-cycle theory. Proposed by
Raymond Vernon, this theory suggests that early in their life cycle, most new products
are produced in and exported from the country in which they were developed. As a
new product becomes widely accepted internationally, however, production starts in

A n o t h e r P e r s p e c t i v e

Outsourcing: Putting Jobs into Growing Markets
Another way of looking at the hollowing out of the Ameri-
can knowledge-based economy through outsourcing is to
see the process from the perspective of developing na-
tions. To them, outsourcing brings with it the benefits of
trade. It is one of the positive outcomes of globalization.
Multinational corporations doing some business in their
markets can locate their production in the very markets
into which they are selling. As India, the Philippines, and
China develop a knowledge-based labor supply, compa-
nies such as Intel and EMC that are selling into these mar-
kets may want to locate some of their research and
development and other knowledge-based activities in
these markets as a commitment to a local presence, as a
way to learn more about the customer, and as a way to
establish sustained and sustaining relationships. Yes, there
are cost savings, especially on labor, but long term, such
cost savings may be secondary.

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Chapter Five International Trade Theory 165

other countries. As a result, the theory suggests, the product may ultimately be
exported back to the country of its original innovation.
In a similar vein, during the 1980s economists such as Nobel Prize winner Paul
Krugman developed what has come to be known as the new trade theory . New trade
theory (for which Krugman won the Nobel Prize in 2008) stresses that in some cases
countries specialize in the production and export of particular products not because
of underlying differences in factor endowments, but because in certain industries
the world market can support only a limited number of firms. (This is argued to be
the case for the commercial aircraft industry.) In such industries, firms that enter the
market first are able to build a competitive advantage that is subsequently difficult to
challenge. Thus, the observed pattern of trade between nations may be due in part to
the ability of firms within a given nation to capture first-mover advantages. The
United States is a major exporter of commercial jet aircraft because American firms
such as Boeing were first movers in the world market. Boeing built a competitive
advantage that has subsequently been difficult for firms from countries with equally
favorable factor endowments to challenge (although Europe’s Airbus Industries has
succeeded in doing that). In a work related to the new trade theory, Michael Porter
developed a theory, referred to as the theory of national competitive advantage. This
attempts to explain why particular nations achieve international success in particular
industries. In addition to factor endowments, Porter points out the importance of
country factors such as domestic demand and domestic rivalry in explaining a nation’s
dominance in the production and export of particular products.

TRADE THEORY AND GOVERNMENT POLICY Although all these the-
ories agree that international trade is beneficial to a country, they lack agreement in
their recommendations for government policy. Mercantilism makes a crude case for
government involvement in promoting exports and limiting imports. The theories of
Smith, Ricardo, and Heckscher-Ohlin form part of the case for unrestricted free trade.
The argument for unrestricted free trade is that both import controls and export in-
centives (such as subsidies) are self-defeating and result in wasted resources. Both the
new trade theory and Porter’s theory of national competitive advantage can be inter-
preted as justifying some limited government intervention to support the develop-
ment of certain export-oriented industries. We will discuss the pros and cons of this
argument, known as strategic trade policy, as well as the pros and cons of the argument
for unrestricted free trade, in Chapter 6.

Mercantilism
The first theory of international trade, mercantilism, emerged in England in the mid-
sixteenth century. The principle assertion of mercantilism was that gold and silver
were the mainstays of national wealth and essential to vigorous commerce. At that
time, gold and silver were the currency of trade between countries; a country could
earn gold and silver by exporting goods. Conversely, importing goods from other
countries would result in an outflow of gold and silver to those countries. The main
tenet of mercantilism was that it was in a country’s best interests to maintain a trade
surplus, to export more than it imported. By doing so, a country would accumulate
gold and silver and, consequently, increase its national wealth, prestige, and power. As
the English mercantilist writer Thomas Mun put it in 1630:

The ordinary means therefore to increase our wealth and treasure is by foreign
trade, wherein we must ever observe this rule: to sell more to strangers yearly
than we consume of theirs in value. 1

New Trade Theory
Theory that sometimes
countries specialize in
the production and
export of particular
products not because of
underlying differences in
factor endowments, but
because in certain
industries the world
market can support only
a limited number of firms.

Mercantilism
An economic philosophy
advocating that countries
should simultaneously
encourage exports and
discourage imports.

LEARNING OBJECTIVE 2
Summarize the different

theories explaining trade
flows between nations.

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166 Part Three Cross-Border Trade and Investment

Consistent with this belief, the mercantilist doctrine advocated government interven-
tion to achieve a surplus in the balance of trade. The mercantilists saw no virtue in a
large volume of trade. Rather, they recommended policies to maximize exports and
minimize imports. To achieve this, imports were limited by tariffs and quotas, while
exports were subsidized.
The classical economist David Hume pointed out an inherent inconsistency in the
mercantilist doctrine in 1752. According to Hume, if England had a balance-of-trade
surplus with France (it exported more than it imported) the resulting inflow of gold
and silver would swell the domestic money supply and generate inflation in England.
In France, however, the outflow of gold and silver would have the opposite effect.
France’s money supply would contract, and its prices would fall. This change in rela-
tive prices between France and England would encourage the French to buy fewer
English goods (because they were becoming more expensive) and the English to buy
more French goods (because they were becoming cheaper). The result would be a
deterioration in the English balance of trade and an improvement in France’s trade
balance, until the English surplus was eliminated. Hence, according to Hume, in the

Is China a Neo-mercantilist Nation?

China’s rapid rise in economic power has been built on
export-led growth. The country, using its cheap labor, has
converted raw material imports into products that it sells to
developed nations. For years, the country’s exports have
been growing faster than its imports, leading some critics
to claim that China is pursuing a neo-mercantilist policy,
trying to amass record trade surpluses and foreign
currency that will give it economic power over developed
nations. This rhetoric reached new heights in 2008 when
China’s trade surplus hit a record $280 billion and its foreign
exchange reserves exceeded $1.95 trillion, some 70 per-
cent of which are held in U.S. dollars. Observers worry
that if China ever decides to sell its holdings of U.S. cur-
rency, this could depress the value of the dollar against
other currencies and increase the price of imports into
America.
Throughout 2005–2008, China’s exports grew much
faster than its imports, leading some to argue that China
was limiting imports by pursuing an import substitution
policy, encouraging domestic investment in the produc-
tion of products such as steel, aluminum, and paper,
which it had historically imported from other nations. The
trade deficit with the United States has been a particular
cause for concern. In 2008, this reached $260 billion, the
largest deficit ever recorded with a single country. At the
same time, China has long resisted attempts to let its
currency float freely against the U.S. dollar. Many claim
that China’s currency is too cheap, and that this keeps the

prices of China’s goods artificially low, which fuels the
country’s exports.
So is China a neo-mercantilist nation that is deliberately
discouraging imports and encouraging exports in order to
grow its trade surplus and accumulate foreign exchange
reserves, which might give it economic power? The jury is
out on this issue. Skeptics suggest that the slowdown in
imports to China is temporary and that the country will
have no choice but to increase imports of commodities that
it lacks, such as oil. They also note that China did start
allowing the value of the renminbi (China’s currency) to
appreciate against the dollar in July 2005, and between then
and January 2010 it appreciated 17 percent in value. More-
over, although China’s overall trade surplus was up sharply
in 2008, import growth exceeded export growth for 2008,
and exports slowed sharply toward the end of the year as
the global economic crisis took hold. In 2009, China’s trade
surplus contracted somewhat, and its deficit with America
appears to have shrunk by some $100 billion, as the global
economic crisis of 2008–2009 hit Chinese exporters hard.
While this suggests that China’s trade surplus may have
peaked for now, it is still significant.

Source: A. Browne, “China’s Wild Swings Can Roil the Global Economy,”
The Wall Street Journal , October 24, 2005, p. A2; S. H. Hanke, “Stop the
Mercantilists,” Forbes , June 20, 2005, p. 164; G. Dyer and A. Balls, “Dollar
Threat as China Signals Shift,” Financial Times , January 6, 2006, p. 1;
Tim Annett, “Righting the Balance,” The Wall Street Journal , January 10,
2007, p. 15; “China’s Trade Surplus Peaks,” Financial Times , January 12,
2008, p. 1; and W. Chong, “China’s Trade Surplus to U.S. to Narrow,”
China Daily , December 7, 2009.

3 C o u n t r y F O C U S

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Chapter Five International Trade Theory 167

long run no country could sustain a surplus on the balance of trade and so accumulate
gold and silver as the mercantilists had envisaged.
The flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-
sum game is one in which a gain by one country results in a loss by another.) It was
left to Adam Smith and David Ricardo to show the shortsightedness of this approach
and to demonstrate that trade is a positive-sum game, or a situation in which all coun-
tries can benefit. Unfortunately, the mercantilist doctrine is by no means dead. Neo-
mercantilists equate political power with economic power and economic power with a
balance-of-trade surplus. Critics argue that many nations have adopted a neo-mercantilist
strategy that is designed to simultaneously boost exports and limit imports. 2 For exam-
ple, critics charge that China is pursuing a neo-mercantilist policy, deliberately keeping
its currency value low against the U.S. dollar in order to sell more goods to the United
States, and thus amass a trade surplus and foreign exchange reserves (see the accompa-
nying Country Focus).

Absolute Advantage
In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercan-
tilist assumption that trade is a zero-sum game. Smith argued that countries differ
in their ability to produce goods efficiently. In his time, the English, by virtue of
their superior manufacturing processes, were the world’s most efficient textile man-
ufacturers. Due to the combination of favorable climate, good soils, and accumu-
lated expertise, the French had the world’s most efficient wine industry. The
English had an absolute advantage in the production of textiles, while the French had
an absolute advantage in the production of wine. Thus, a country has an absolute
advantage in the production of a product when it is more efficient than any other
country in producing it.
According to Smith, countries should specialize in the production of goods for
which they have an absolute advantage and then trade these for goods produced by
other countries. In Smith’s time, this suggested that the English should specialize in
the production of textiles while the French should specialize in the production of
wine. England could get all the wine it needed by selling its textiles to France and
buying wine in exchange. Similarly, France could get all the textiles it needed by
selling wine to England and buying textiles in exchange. Smith’s basic argument,
therefore, is that a country should never produce goods at home that it can buy at a
lower cost from other countries. Smith demonstrates that, by specializing in the
production of goods in which each has an absolute advantage, both countries benefit
by engaging in trade.
Consider the effects of trade between two countries, Ghana and South Korea.
The production of any good (output) requires resources (inputs) such as land, labor,
and capital. Assume that Ghana and South Korea both have the same amount of
resources and that these resources can be used to produce either rice or cocoa. As-
sume further that 200 units of resources are available in each country. Imagine that
in Ghana it takes 10 resources to produce one ton of cocoa and 20 resources to
produce one ton of rice. Thus, Ghana could produce 20 tons of cocoa and no rice,
10 tons of rice and no cocoa, or some combination of rice and cocoa between these
two extremes. The different combinations that Ghana could produce are repre-
sented by the line GG’ in Figure 5.1. This is referred to as Ghana’s production pos-
sibility frontier (PPF). Similarly, imagine that in South Korea it takes 40 resources to
produce one ton of cocoa and 10 resources to produce one ton of rice. Thus, South
Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or

Zero-Sum Game
A situation in which an
economic gain by one
country results in an
economic loss by
another.

Absolute Advantage
A country has an
absolute advantage
in the production of a
product when it is more
efficient than any other
country in producing it.

LEARNING OBJECTIVE 2
Summarize the different

theories explaining trade
flows between nations.

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168 Part Three Cross-Border Trade and Investment

some combination between these two extremes. The different combinations avail-
able to South Korea are represented by the line KK’ in Figure 5.1, which is South
Korea’s PPF. Clearly, Ghana has an absolute advantage in the production of cocoa.
(More resources are needed to produce a ton of cocoa in South Korea than in
Ghana.) By the same token, South Korea has an absolute advantage in the produc-
tion of rice.
Now consider a situation in which neither country trades with any other. Each coun-
try devotes half of its resources to the production of rice and half to the production of
cocoa. Each country must also consume what it produces. Ghana would be able to
produce 10 tons of cocoa and 5 tons of rice (point A in Figure 5.1), while South Korea
would be able to produce 10 tons of rice and 2.5 tons of cocoa (point B in Figure 5.1).
Without trade, the combined production of both countries would be 12.5 tons of
cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15 tons of rice (5 tons in
Ghana and 10 tons in South Korea). If each country were to specialize in producing
the good for which it had an absolute advantage and then trade with the other for the
good it lacks, Ghana could produce 20 tons of cocoa, and South Korea could produce
20 tons of rice. Thus, by specializing, the production of both goods could be increased.
Production of cocoa would increase from 12.5 tons to 20 tons, while production of
rice would increase from 15 tons to 20 tons. The increase in production that would
result from specialization is therefore 7.5 tons of cocoa and 5 tons of rice. Table 5.1
summarizes these figures.
By engaging in trade and swapping one ton of cocoa for one ton of rice, producers
in both countries could consume more of both cocoa and rice. Imagine that Ghana
and South Korea swap cocoa and rice on a one-to-one basis; that is, the price of one
ton of cocoa is equal to the price of one ton of rice. If Ghana decided to export 6 tons
of cocoa to South Korea and import 6 tons of rice in return, its final consumption after
trade would be 14 tons of cocoa and 6 tons of rice. This is 4 tons more cocoa than it
could have consumed before specialization and trade and 1 ton more rice. Similarly,
South Korea’s final consumption after trade would be 6 tons of cocoa and 14 tons of
rice. This is 3.5 tons more cocoa than it could have consumed before specialization
and trade and 4 tons more rice. Thus, as a result of specialization and trade, output of
both cocoa and rice would be increased, and consumers in both nations would be able
to consume more. Thus, we can see that trade is a positive-sum game; it produces net
gains for all involved.

figure 5.1

The Theory of Absolute
Advantage

5 10 15 20

Rice

10
A

G’

K’

Co
co

2.5

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Chapter Five International Trade Theory 169

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa Rice

Ghana 10 20

South Korea 40 10

Production and Consumption without Trade

Cocoa Rice

Ghana 10.0 5.0

South Korea 2.5 10.0

Total production 12.5 15.0

Production with Specialization

Cocoa Rice

Ghana 20.0 0.0

South Korea 0.0 20.0

Total production 20.0 20.0

Consumption after Ghana Trades 6 Tons of Cocoa for 6 Tons
of South Korean Rice

Cocoa Rice

Ghana 14.0 6.0

South Korea 6.0 14.0

Increase in Consumption as a Result of Specialization and Trade

Cocoa Rice

Ghana 4.0 1.0

South Korea 3.5 4.0

Comparative Advantage
David Ricardo took Adam Smith’s theory one step further by exploring what might
happen when one country has an absolute advantage in the production of all goods. 3
Smith’s theory of absolute advantage suggests that such a country might derive no
benefits from international trade. In his 1817 book Principles of Political Economy,
Ricardo showed that this was not the case. According to Ricardo’s theory of comparative
advantage, it makes sense for a country to specialize in the production of those goods
that it produces most efficiently and to buy the goods that it produces less efficiently
from other countries, even if this means buying goods from other countries that it
could produce more efficiently itself. 4 While this may seem counterintuitive, the logic
can be explained with a simple example.

LEARNING OBJECTIVE 2
Summarize the different
theories explaining trade
flows between nations.

5.1 table

Absolute Advantage
and the Gains
from Trade

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170 Part Three Cross-Border Trade and Investment

Assume that Ghana is more efficient in the production of both cocoa and rice;
that is, Ghana has an absolute advantage in the production of both products. In
Ghana it takes 10 resources to produce one ton of cocoa and 131/3 resources to
produce one ton of rice. Thus, given its 200 units of resources, Ghana can produce
20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or any combination in
between on its PPF (the line GG’ in Figure 5.2). In South Korea it takes 40 re-
sources to produce one ton of cocoa and 20 resources to produce one ton of rice.
Thus, South Korea can produce 5 tons of cocoa and no rice, 10 tons of rice and no
cocoa, or any combination on its PPF (the line KK’ in Figure 5.2). Again assume that
without trade, each country uses half of its resources to produce rice and half to pro-
duce cocoa. Thus, without trade, Ghana will produce 10 tons of cocoa and 7.5 tons
of rice (point A in Figure 5.2), while South Korea will produce 2.5 tons of cocoa and
5 tons of rice (point B in Figure 5.2).
In light of Ghana’s absolute advantage in the production of both goods, why should it
trade with South Korea? Although Ghana has an absolute advantage in the production
of both cocoa and rice, it has a comparative advantage only in the production of cocoa:
Ghana can produce 4 times as much cocoa as South Korea, but only 1.5 times as much
rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice.
Without trade the combined production of cocoa will be 12.5 tons (10 tons in
Ghana and 2.5 in South Korea), and the combined production of rice will also be
12.5 tons (7.5 tons in Ghana and 5 tons in South Korea). Without trade each country
must consume what it produces. By engaging in trade, the two countries can increase
their combined production of rice and cocoa, and consumers in both nations can con-
sume more of both goods.

THE GAINS FROM TRADE Imagine that Ghana exploits its comparative
advantage in the production of cocoa to increase its output from 10 tons to 15 tons. This
uses 150 units of resources, leaving the remaining 50 units of resources to use in pro-
ducing 3.75 tons of rice (point C in Figure 5.2). Meanwhile, South Korea specializes
in the production of rice, producing 10 tons. The combined output of both cocoa and
rice has now increased. Before specialization, the combined output was 12.5 tons of
cocoa and 12.5 tons of rice. Now it is 15 tons of cocoa and 13.75 tons of rice (3.75 tons
in Ghana and 10 tons in South Korea). The source of the increase in production is
summarized in Table 5.2.

figure 5.2

The Theory of
Comparative Advantage

K
G
A
G’
B
K’
C

5 7.53.75 10 15 200

Rice
20
15

10Co
co

a
5
2.5

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Chapter Five International Trade Theory 171

Not only is output higher, but both countries also can now benefit from trade. If
Ghana and South Korea swap cocoa and rice on a one-to-one basis, with both countries
choosing to exchange 4 tons of their export for 4 tons of the import, both countries are
able to consume more cocoa and rice than they could before specialization and trade
(see Table 5.2). Thus, if Ghana exchanges 4 tons of cocoa with South Korea for 4 tons
of rice, it is still left with 11 tons of cocoa, which is 1 ton more than it had before trade.
The 4 tons of rice it gets from South Korea in exchange for its 4 tons of cocoa, when
added to the 3.75 tons it now produces domestically, leaves it with a total of 7.75 tons
of rice, which is .25 of a ton more than it had before specialization. Similarly, after
swapping 4 tons of rice with Ghana, South Korea still ends up with 6 tons of rice, which
is more than it had before specialization. In addition, the 4 tons of cocoa it receives in
exchange is 1.5 tons more than it produced before trade. Thus, consumption of cocoa
and rice can increase in both countries as a result of specialization and trade.

Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice

Ghana 10 13.33

South Korea 40 20

Production and Consumption without Trade
Cocoa Rice

Ghana 10.0 7.5

South Korea 2.5 5.0

Total production 12.5 12.5

Production with Specialization
Cocoa Rice

Ghana 15.0 3.75

South Korea 0.0 10.0

Total production 15.0 13.75

Consumption after Ghana Trades 4 Tons of Cocoa for 4 Tons
of South Korean Rice

Cocoa Rice

Ghana 11.0 7.75

South Korea 4.0 6.0

Increase in Consumption as a Result of Specialization and Trade
Cocoa Rice

Ghana 1.0 0.25

South Korea 1.5 1.0

5.2 table

Comparative
Advantage and the
Gains from Trade

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172 Part Three Cross-Border Trade and Investment

The basic message of the theory of comparative advantage is that potential world
production is greater with unrestricted free trade than it is with restricted trade. Ricardo’s
theory suggests that consumers in all nations can consume more if there are no re-
strictions on trade. This occurs even in countries that lack an absolute advantage in the
production of any good. In other words, to an even greater degree than the theory of
absolute advantage, the theory of comparative advantage suggests that trade is a positive-sum
game in which all countries that participate realize economic gains. As such, this theory pro-
vides a strong rationale for encouraging free trade. So powerful is Ricardo’s theory
that it remains a major intellectual weapon for those who argue for free trade.

QUALIFICATIONS AND ASSUMPTIONS The conclusion that free trade
is universally beneficial is a rather bold one to draw from such a simple model. Our
simple model includes many unrealistic assumptions:

1. We have assumed a simple world in which there are only two countries and two
goods. In the real world, there are many countries and many goods.

2. We have assumed away transportation costs between countries.
3. We have assumed away differences in the prices of resources in different countries.

We have said nothing about exchange rates, simply assuming that cocoa and rice
could be swapped on a one-to-one basis.

4. We have assumed that resources can move freely from the production of one good
to another within a country. In reality, this is not always the case.

5. We have assumed constant returns to scale; that is, that specialization by Ghana or
South Korea has no effect on the amount of resources required to produce one
ton of cocoa or rice. In reality, both diminishing and increasing returns to
specialization exist. The amount of resources required to produce a good might
decrease or increase as a nation specializes in production of that good.

6. We have assumed that each country has a fixed stock of resources and that free
trade does not change the efficiency with which a country uses its resources. This
static assumption makes no allowances for the dynamic changes in a country’s
stock of resources and in the efficiency with which the country uses its resources
that might result from free trade.

7. We have assumed away the effects of trade on income distribution within a
country.

Given these assumptions, can the conclusion that free trade is mutually beneficial
be extended to the real world of many countries, many goods, positive transportation
costs, volatile exchange rates, immobile domestic resources, non-constant returns to
specialization, and dynamic changes? Although a detailed extension of the theory of
comparative advantage is beyond the scope of this book, economists have shown that
the basic result derived from our simple model can be generalized to a world com-
posed of many countries producing many different goods. 5 Despite the shortcomings
of the Ricardian model, research suggests that the basic proposition that countries will
export the goods that they are most efficient at producing is borne out by the data. 6
However, once all the assumptions are dropped, the case for unrestricted free trade,
while still positive, has been argued by some economists associated with the “new
trade theory” to lose some of its strength. 7 We return to this issue later in this chapter
and in the next when we discuss the new trade theory. Moreover, in a recent and
widely discussed analysis, the Nobel Prize winning economist Paul Samuelson argued
that contrary to the standard interpretation, in certain circumstances the theory of
comparative advantage predicts that a rich country might actually be worse off by
switching to a free trade regime with a poor nation. 8 We will consider Samuelson’s
critique in the next section.

LEARNING OBJECTIVE 3
Recognize why many

economists believe that
unrestricted free trade

between nations will raise
the economic welfare of

countries that participate in
a free trade system.

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Chapter Five International Trade Theory 173

EXTENSIONS OF THE RICARDIAN MODEL Let us explore the effect of
relaxing three of the assumptions identified above in the simple comparative advan-
tage model. Below we relax the assumptions that resources move freely from the pro-
duction of one good to another within a country, that there are constant returns to
scale, and that trade does not change a country’s stock of resources or the efficiency
with which those resources are utilized.

Immobile Resources In our simple comparative model of Ghana and South
Korea, we assumed that producers (farmers) could easily convert land from the pro-
duction of cocoa to rice, and vice versa. While this assumption may hold for some
agricultural products, resources do not always shift quite so easily from producing
one good to another. A certain amount of friction is involved. For example, embrac-
ing a free trade regime for an advanced economy such as the United States often
implies that the country will produce less of some labor-intensive goods, such as tex-
tiles, and more of some knowledge-intensive goods, such as computer software or
biotechnology products. Although the country as a whole will gain from such a shift,
textile producers will lose. A textile worker in South Carolina is probably not quali-
fied to write software for Microsoft. Thus, the shift to free trade may mean that she
becomes unemployed or has to accept another less attractive job, such as working at
a fast-food restaurant.
Resources do not always move easily from one economic activity to another. The
process creates friction and human suffering too. While the theory predicts that the
benefits of free trade outweigh the costs by a significant margin, this is of cold comfort
to those who bear the costs. Accordingly, political opposition to the adoption of a free
trade regime typically comes from those whose jobs are most at risk. In the United
States, for example, textile workers and their unions have long opposed the move
toward free trade precisely because this group has much to lose from free trade. Govern-
ments often ease the transition toward free trade by helping to retrain those who lose
their jobs as a result. The pain caused by the movement toward a free trade regime is
a short-term phenomenon, while the gains from trade once the transition has been
made are both significant and enduring.

Diminishing Returns The simple comparative advantage model developed above
assumes constant returns to specialization. By constant returns to specialization we
mean the units of resources required to produce a good (cocoa or rice) are assumed to
remain constant no matter where one is on a country’s production possibility frontier
(PPF). Thus, we assumed that it always took Ghana 10 units of resources to produce
one ton of cocoa. However, it is more realistic to assume diminishing returns to special-
ization. Diminishing returns to specialization occurs when more units of resources are
required to produce each additional unit. While 10 units of resources may be sufficient
to increase Ghana’s output of cocoa from 12 tons to 13 tons, 11 units of resources may
be needed to increase output from 13 to 14 tons, 12 units of resources to increase out-
put from 14 tons to 15 tons, and so on. Diminishing returns implies a convex PPF for
Ghana (see Figure 5.3), rather than the straight line depicted in Figure 5.2.
It is more realistic to assume diminishing returns for two reasons. First, not all
resources are of the same quality. As a country tries to increase its output of a certain
good, it is increasingly likely to draw on more marginal resources whose productivity
is not as great as those initially employed. The result is that it requires ever more
resources to produce an equal increase in output. For example, some land is more pro-
ductive than other land. As Ghana tries to expand its output of cocoa, it might have to
utilize increasingly marginal land that is less fertile than the land it originally used. As
yields per acre decline, Ghana must use more land to produce one ton of cocoa.

Constant Returns
to Specialization
The units of resources
required to produce a
good are assumed to
remain constant no
matter where one is on
a country’s production
possibility frontier.

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174 Part Three Cross-Border Trade and Investment

A second reason for diminishing returns is that different goods use resources in dif-
ferent proportions. For example, imagine that growing cocoa uses more land and less
labor than growing rice, and that Ghana tries to transfer resources from rice produc-
tion to cocoa production. The rice industry will release proportionately too much
labor and too little land for efficient cocoa production. To absorb the additional
resources of labor and land, the cocoa industry will have to shift toward more labor-
intensive methods of production. The effect is that the efficiency with which the cocoa
industry uses labor will decline, and returns will diminish.
Diminishing returns show that it is not feasible for a country to specialize to the
degree suggested by the simple Ricardian model outlined earlier. Diminishing returns
to specialization suggest that the gains from specialization are likely to be exhausted
before specialization is complete. In reality, most countries do not specialize, but in-
stead, produce a range of goods. However, the theory predicts that it is worthwhile to
specialize until that point where the resulting gains from trade are outweighed by di-
minishing returns. Thus, the basic conclusion that unrestricted free trade is beneficial
still holds, although because of diminishing returns, the gains may not be as great as
suggested in the constant returns case.

Dynamic Effects and Economic Growth The simple comparative advantage
model assumed that trade does not change a country’s stock of resources or the effi-
ciency with which it utilizes those resources. This static assumption makes no allow-
ances for the dynamic changes that might result from trade. If we relax this
assumption, it becomes apparent that opening an economy to trade is likely to gener-
ate dynamic gains of two sorts. 9 First, free trade might increase a country’s stock of
resources as increased supplies of labor and capital from abroad become available for
use within the country. For example, this has been occurring in Eastern Europe since
the early 1990s, with many Western businesses investing significant capital in the
former Communist countries.
Second, free trade might also increase the efficiency with which a country uses its
resources. Gains in the efficiency of resource utilization could arise from a number of fac-
tors. For example, economies of large-scale production might become available as trade
expands the size of the total market available to domestic firms. Trade might make better
technology from abroad available to domestic firms; better technology can increase labor

G
G’
Co
co

Rice0

figure 5.3

Ghana’s PPF under
Diminishing Returns

LEARNING OBJECTIVE 3
Recognize why many
economists believe that
unrestricted free trade
between nations will raise
the economic welfare of
countries that participate
in a free trade system.

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Chapter Five International Trade Theory 175

productivity or the productivity of land. (The so-called green revolution had this effect
on agricultural outputs in developing countries.) Also, opening an economy to foreign
competition might stimulate domestic producers to look for ways to increase their effi-
ciency. Again, this phenomenon has arguably been occurring in the once-protected mar-
kets of Eastern Europe, where many former state monopolies have had to increase the
efficiency of their operations to survive in the competitive world market.
Dynamic gains in both the stock of a country’s resources and the efficiency with which
resources are utilized will cause a country’s PPF to shift outward. This is illustrated in
Figure 5.4, where the shift from PPF 1 to PPF 2 results from the dynamic gains that arise
from free trade. As a consequence of this outward shift, the country in Figure 5.4 can
produce more of both goods than it did before introduction of free trade. The theory
suggests that opening an economy to free trade not only results in static gains of the type
discussed earlier, but also results in dynamic gains that stimulate economic growth. If this
is so, then one might think that the case for free trade becomes stronger still, and in gen-
eral it does. However, as noted above, in a recent article one of the leading economic
theorists of the twentieth century, Paul Samuelson, argued that in some circumstances,
dynamic gains can lead to an outcome that is not so beneficial.

The Samuelson Critique Paul Samuelson’s critique looks at what happens
when a rich country—the United States—enters into a free trade agreement with a
poor country—China—that rapidly improves its productivity after the introduction of
a free trade regime (i.e., there is a dynamic gain in the efficiency with which resources
are used in the poor country). Samuelson’s model suggests that in such cases, the lower
prices that U.S. consumers pay for goods imported from China following the intro-
duction of a free trade regime may not be enough to produce a net gain to for the U.S.
economy if the dynamic effect of free trade is to lower real wage rates in the United
States. As he stated in a New York Times interview, “Being able to purchase groceries
20 percent cheaper at Walmart (due to international trade) does not necessarily make
up for the wage losses (in America).” 10
Samuelson goes on to note that he is particularly concerned about the ability to off-
shore service jobs that traditionally were not internationally mobile, such as software
debugging, call center jobs, accounting jobs, and even medical diagnosis of MRI scans
(see the accompanying Country Focus for details). Recent advances in communications

Co
co
a
Rice0

PPF2

PPF1

5.4 figure

The Influence of Free
Trade on the PPF

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176 Part Three Cross-Border Trade and Investment

technology have made this possible, effectively expanding the labor market for these jobs
to include educated people in places such as India, the Philippines, and China. When
coupled with rapid advances in the productivity of foreign labor due to better education,
the effect on middle-class wages in the United States, according to Samuelson, may be
similar to mass inward migration into the United States—it will lower the market clear-
ing wage rate, perhaps by enough to outweigh the positive benefits of international trade.
Having said this, it should be noted that Samuelson concedes that free trade has
historically benefited rich counties (as data discussed below seem to confirm). More-
over, he notes that introducing protectionist measures (e.g., trade barriers) to guard
against the theoretical possibility that free trade may harm the United States in the
future may produce a situation that is worse than the disease the measures are trying
to prevent. To quote Samuelson: “Free trade may turn out pragmatically to be still best

Moving U.S. White-Collar Jobs Offshore

Economists have long argued that free trade produces
gains for all countries that participate in a free trading sys-
tem, but as the next wave of globalization sweeps through
the U.S. economy, many people are wondering if this is true,
particularly those who stand to lose their jobs because of
this wave of globalization. In the popular imagination for
much of the past quarter century, free trade was associated
with the movement of low-skill, blue-collar manufacturing
jobs out of rich countries such as the United States and to-
ward low-wage countries—textiles to Costa Rica, athletic
shoes to the Philippines, steel to Brazil, electronic products
to Malaysia, and so on. While many observers bemoaned
the “hollowing out” of U.S. manufacturing, economists
stated that high-skilled and high-wage white-collar jobs
associated with the knowledge-based economy would stay
in the United States. Computers might be assembled in
Malaysia, so the argument went, but they would continue to
be designed in Silicon Valley by high-skilled U.S. engineers.
Recent developments have some people questioning this
assumption. As the global economy slowed after 2000
and corporate profits fell, many American companies
responded by moving white-collar “knowledge-based” jobs
to developing nations where they could be performed for a
fraction of the cost. During the long economic boom of the
1990s, Bank of America had to compete with other organi-
zations for the scarce talents of information technology
specialists, driving annual salaries to more than $100,000.
However, with business under pressure, the bank cut
nearly 5,000 jobs from its 25,000-strong U.S.-based IT work-
force. Some of these jobs were transferred to India, where
work that costs $100 an hour in the United States can be
done for $20 an hour.
One beneficiary of Bank of America’s downsizing is
Infosys Technologies Ltd., a Bangalore, India, information

technology firm where 250 engineers now develop IT
applications for the bank. Other Infosys employees are
busy processing home loan applications for Greenpoint
Mortgage of Novato, California. Nearby in the offices of
another Indian firm, Wipro Ltd., five radiologists interpret
30 CT scans a day for Massachusetts General Hospital
that are sent over the Internet. At yet another Bangalore
business, engineers earn $10,000 a year designing leading-
edge semiconductor chips for Texas Instruments. Nor is
India the only beneficiary of these changes. Accenture, a
large U.S. management consulting and information tech-
nology firm, moved 5,000 jobs in software development
and accounting to the Philippines. Also in the Philippines,
Procter & Gamble employs 650 professionals who prepare
the company’s global tax returns. The work used to be
done in the United States, but now it is done in Manila,
with just final submission to local tax authorities in the
United States and other countries handled locally.
Some architectural work also is being outsourced to
lower-cost locations. Fluor Corp., a Texas-based construc-
tion company, employs some 1,200 engineers and drafts-
men in the Philippines, Poland, and India to turn layouts of
industrial facilities into detailed specifications. For a Saudi
Arabian chemical plant Fluor is designing, 200 young engi-
neers based in the Philippines earning less than $3,000 a
year collaborate in real time over the Internet with elite
U.S. and British engineers who make up to $90,000 a year.
Why does Fluor do this? According to the company, the
answer is simple. Doing so reduces the prices of a project by
15 percent, giving the company a cost-based competitive
advantage in the global market for construction design.

Sources: P. Engardio, A. Bernstein, and M. Kripalani, “Is Your Job Next?”
BusinessWeek, February 3, 2003, pp. 50–60; “America’s Pain, India’s Gain,”
The Economist, January 11, 2003, p. 57; and M. Schroeder and T. Aeppel,
“Skilled Workers Mount Opposition to Free Trade, Swaying Politicians,”
The Wall Street Journal , October 10, 2003, pp. A1, A11.

3 C o u n t r y F O C U S

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Chapter Five International Trade Theory 177

for each region in comparison to lobbyist-induced tariffs and quotas which involve
both a perversion of democracy and non-subtle deadweight distortion losses.” 11
Some economists have been quick to dismiss Samuelson’s fears. 12 While not ques-
tioning his analysis, they note that developing nations are unlikely to be able to up-
grade the skill level of their workforce rapidly enough to give rise to the situation in
Samuelson’s model. In other words, the countries will quickly run into diminishing
returns. To quote one such rebuttal: “The notion that India and China will quickly
educate 300 million of their citizens to acquire sophisticated and complex skills at
stake borders on the ludicrous. The educational sectors in these countries face enor-
mous difficulties.” 13 Notwithstanding such rebuttals, however, Samuelson’s stature is
such that his work will undoubtedly be debated for some time.

Evidence for the Link between Trade and Growth Many economic studies
have looked at the relationship between trade and economic growth. 14 In general,
these studies suggest that, as predicted by the standard theory of comparative advan-
tage, countries that adopt a more open stance toward international trade enjoy higher
growth rates than those that close their economies to trade (the opening case provides
evidence of the link between trade and growth). Jeffrey Sachs and Andrew Warner cre-
ated a measure of how “open” to international trade an economy was and then looked
at the relationship between “openness” and economic growth for a sample of more
than 100 countries from 1970 to 1990. 15 Among other findings, they reported:

We find a strong association between openness and growth, both within the
group of developing and the group of developed countries. Within the group of
developing countries, the open economies grew at 4.49 percent per year, and the
closed economies grew at 0.69 percent per year. Within the group of developed
economies, the open economies grew at 2.29 percent per year, and the closed
economies grew at 0.74 percent per year. 16

A study by Wacziarg and Welch updated the Sachs and Warner data through the late
1990s. They found that from 1950 to 1998, countries that liberalized their trade re-
gimes experienced, on average, increases in their annual growth rates of 1.5 percent
compared to preliberalization times. 17
The message of these studies seems clear: Adopt an open economy and embrace
free trade, and your nation will be rewarded with higher economic growth rates.
Higher growth will raise income levels and living standards. This last point has been
confirmed by a study that looked at the relationship between trade and growth in
incomes. The study, undertaken by Jeffrey Frankel and David Romer, found that on
average, a one percentage point increase in the ratio of a country’s trade to its gross
domestic product increases income per person by at least one-half percent. 18 For every
10 percent increase in the importance of international trade in an economy, average
income levels will rise by at least 5 percent. Despite the short-term adjustment costs
associated with adopting a free trade regime, trade would seem to produce greater
economic growth and higher living standards in the long run, just as the theory of
Ricardo would lead us to expect. 19

Heckscher-Ohlin Theory
Ricardo’s theory stresses that comparative advantage arises from differences in pro-
ductivity. Thus, whether Ghana is more efficient than South Korea in the production
of cocoa depends on how productively it uses its resources. Ricardo stressed labor
productivity and argued that differences in labor productivity between nations under-
lie the notion of comparative advantage. Swedish economists Eli Heckscher (in 1919)

LEARNING OBJECTIVE 2
Summarize the different
theories explaining trade
flows between nations.
LEARNING OBJECTIVE 3
Recognize why many
economists believe that
unrestricted free trade
between nations will raise
the economic welfare of
countries that participate in
a free trade system.

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178 Part Three Cross-Border Trade and Investment

and Bertil Ohlin (in 1933) put forward a different explanation of comparative advan-
tage. They argued that comparative advantage arises from differences in national fac-
tor endowments. 20 By factor endowments they meant the extent to which a country
is endowed with such resources as land, labor, and capital. Nations have varying fac-
tor endowments, and different factor endowments explain differences in factor costs;
specifically, the more abundant a factor, the lower its cost. The Heckscher-Ohlin
theory predicts that countries will export those goods that make intensive use of
factors that are locally abundant, while importing goods that make intensive use of fac-
tors that are locally scarce. Thus, the Heckscher-Ohlin theory attempts to explain the
pattern of international trade that we observe in the world economy. Like Ricardo’s
theory, the Heckscher-Ohlin theory argues that free trade is beneficial. Unlike
Ricardo’s theory, however, the Heckscher-Ohlin theory argues that the pattern of
international trade is determined by differences in factor endowments, rather than
differences in productivity.
The Heckscher-Ohlin theory has commonsense appeal. For example, the United
States has long been a substantial exporter of agricultural goods, reflecting in part its
unusual abundance of arable land. In contrast, China excels in the export of goods
produced in labor-intensive manufacturing industries, such as textiles and footwear.
This reflects China’s relative abundance of low-cost labor. The United States, which
lacks abundant low-cost labor, has been a primary importer of these goods. Note that
it is relative, not absolute, endowments that are important; a country may have larger
absolute amounts of land and labor than another country, but be relatively abundant in
one of them.

THE LEONTIEF PARADOX The Heckscher-Ohlin theory has been one of the
most influential theoretical ideas in international economics. Most economists prefer
the Heckscher-Ohlin theory to Ricardo’s theory because it makes fewer simplifying
assumptions. Because of its influence, the theory has been subjected to many empirical
tests. Beginning with a famous study published in 1953 by Wassily Leontief (winner
of the Nobel Prize in economics in 1973), many of these tests have raised questions
about the validity of the Heckscher-Ohlin theory. 21 Using the Heckscher-Ohlin theory,
Leontief postulated that since the United States was relatively abundant in capital com-
pared to other nations, the United States would be an exporter of capital-intensive goods
and an importer of labor-intensive goods. To his surprise, however, he found that U.S.
exports were less capital intensive than U.S. imports. Since this result was at variance
with the predictions of the theory, it has become known as the Leontief paradox.
No one is quite sure why we observe the Leontief paradox. One possible explana-
tion is that the United States has a special advantage in producing new products or
goods made with innovative technologies. Such products may be less capital inten-
sive than products whose technology has had time to mature and become suitable
for mass production. Thus, the United States may be exporting goods that heavily
use skilled labor and innovative entrepreneurship, such as computer software, while
importing heavy manufacturing products that use large amounts of capital. Some
empirical studies tend to confirm this. 22 Still, tests of the Heckscher-Ohlin theory
using data for a large number of countries tend to confirm the existence of the
Leontief paradox. 23
This leaves economists with a difficult dilemma. They prefer the Heckscher-Ohlin
theory on theoretical grounds, but it is a relatively poor predictor of real-world inter-
national trade patterns. On the other hand, the theory they regard as being too lim-
ited, Ricardo’s theory of comparative advantage, actually predicts trade patterns with
greater accuracy. The best solution to this dilemma may be to return to the Ricardian
idea that trade patterns are largely driven by international differences in productivity.

Factor
Endowments

The extent to which a
country is endowed with
such resources as land,

labor, and capital.

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Chapter Five International Trade Theory 179

Thus, one might argue that the United States exports commercial aircraft and imports
textiles not because its factor endowments are especially suited to aircraft manufacture
and not suited to textile manufacture, but because the United States is relatively more
efficient at producing aircraft than textiles. A key assumption in the Heckscher-Ohlin
theory is that technologies are the same across countries. This may not be the case.
Differences in technology may lead to differences in productivity, which in turn, drives
international trade patterns. 24 Thus, Japan’s success in exporting automobiles since the
1970s has been not just because of the relative abundance of capital, but also because
of its development of innovative manufacturing technology that enabled it to achieve
higher productivity levels in automobile production than other countries that also had
abundant capital. More recent empirical work suggests that this theoretical explana-
tion may be correct. 25 The new research shows that once differences in technology
across countries are controlled for, countries do indeed export those goods that make
intensive use of factors that are locally abundant, while importing goods that make
intensive use of factors that are locally scarce. In other words, once the impact of dif-
ferences of technology on productivity is controlled for, the Heckscher-Ohlin theory
seems to gain predictive power.

The Product Life-Cycle Theory
Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s. 26
Vernon’s theory was based on the observation that for most of the twentieth century a
very large proportion of the world’s new products had been developed by U.S. firms
and sold first in the U.S. market (e.g., mass-produced automobiles, televisions, instant
cameras, photocopiers, personal computers, and semiconductor chips). To explain this,
Vernon argued that the wealth and size of the U.S. market gave U.S. firms a strong
incentive to develop new consumer products. In addition, the high cost of U.S. labor
gave U.S. firms an incentive to develop cost-saving process innovations.
Just because a new product is developed by a U.S. firm and first sold in the U.S.
market, it does not follow that the product must be produced in the United States. It
could be produced abroad at some low-cost location and then exported back into the
United States. However, Vernon argued that most new products were initially pro-
duced in America. Apparently, the pioneering firms believed it was better to keep pro-
duction facilities close to the market and to the firm’s center of decision making, given
the uncertainty and risks inherent in introducing new products. Also, the demand for
most new products tends to be based on non-price factors. Consequently, firms can
charge relatively high prices for new products, which obviates the need to look for
low-cost production sites in other countries.
Vernon went on to argue that early in the life cycle of a typical new product, while
demand is starting to grow rapidly in the United States, demand in other advanced
countries is limited to high-income groups. The limited initial demand in other
advanced countries does not make it worthwhile for firms in those countries to start
producing the new product, but it does necessitate some exports from the United
States to those countries.
Over time, demand for the new product starts to grow in other advanced countries
(e.g., Great Britain, France, Germany, and Japan). As it does, it becomes worthwhile
for foreign producers to begin producing for their home markets. In addition, U.S.
firms might set up production facilities in those advanced countries where demand is
growing. Consequently, production within other advanced countries begins to limit
the potential for exports from the United States.
As the market in the United States and other advanced nations matures, the prod-
uct becomes more standardized, and price becomes the main competitive weapon. As

LEARNING OBJECTIVE 2
Summarize the different
theories explaining trade
flows between nations.

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180 Part Three Cross-Border Trade and Investment

this occurs, cost considerations start to play a greater role in the competitive process.
Producers based in advanced countries where labor costs are lower than in the United
States (e.g., Italy, Spain) might now be able to export to the United States. If cost
pressures become intense, the process might not stop there. The cycle by which the
United States lost its advantage to other advanced countries might be repeated once
more, as developing countries (e.g., Thailand) begin to acquire a production advan-
tage over advanced countries. Thus, the locus of global production initially switches
from the United States to other advanced nations and then from those nations to
developing countries.
The consequence of these trends for the pattern of world trade is that over time the
United States switches from being an exporter of the product to an importer of the
product as production becomes concentrated in lower-cost foreign locations. Figure 5.5
shows the growth of production and consumption over time in the United States, other
advanced countries, and developing countries.

EVALUATING THE PRODUCT LIFE-CYCLE THEORY Historically, the
product life-cycle theory seems to be an accurate explanation of international trade
patterns. Consider photocopiers; the product was first developed in the early 1960s
by Xerox in the United States and sold initially to U.S. users. Originally Xerox
exported photocopiers from the United States, primarily to Japan and the advanced
countries of Western Europe. As demand began to grow in those countries, Xerox
entered into joint ventures to set up production in Japan (Fuji-Xerox) and Great
Britain (Rank-Xerox). In addition, once Xerox’s patents on the photocopier process
expired, other foreign competitors began to enter the market (e.g., Canon in Japan,
Olivetti in Italy). As a consequence, exports from the United States declined, and U.S.
users began to buy some of their photocopiers from lower-cost foreign sources, par-
ticularly Japan. More recently, Japanese companies have found that manufacturing
costs are too high in their own country, so they have begun to switch production to
developing countries such as Singapore and Thailand. Thus, initially the United
States and now other advanced countries (e.g., Japan and Great Britain) have switched
from being exporters of photocopiers to importers. This evolution in the pattern of
international trade in photocopiers is consistent with the predictions of the product
life-cycle theory that mature industries tend to go out of the United States and into
low-cost assembly locations.
However, the product life-cycle theory is not without weaknesses. Viewed from
an Asian or European perspective, Vernon’s argument that most new products are
developed and introduced in the United States seems ethnocentric and increasingly
dated. Although it may be true that during U.S. dominance of the global economy
(from 1945 to 1975), most new products were introduced in the United States, there
have always been important exceptions. These exceptions appear to have become
more common in recent years. Many new products are now first introduced in Japan
(e.g., videogame consoles) or Europe (new wireless phones). Moreover, with the in-
creased globalization and integration of the world economy discussed in Chapter 1,
a growing number of new products (e.g., laptop computers, compact disks, and digi-
tal cameras) are now introduced simultaneously in the United States, Japan, and the
advanced European nations. This may be accompanied by globally dispersed pro-
duction, with particular components of a new product being produced in those loca-
tions around the globe where the mix of factor costs and skills is most favorable (as
predicted by the theory of comparative advantage). In sum, although Vernon’s the-
ory may be useful for explaining the pattern of international trade during the brief
period of American global dominance, its relevance in the modern world seems
more limited.

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Chapter Five International Trade Theory 181

120

100

60
40
20
0

160

140

120
100
80
60
40
20
0
160
140
120
100
80
60
40
20
0

A. United States

B. Other advanced countries

C. Developing countries

Exports

Production

Consumption

Production
Consumption
Production
Consumption

Maturing
product

New
product

Standardized
product

Stages of product development

Exports
Imports

Expo
rts

Imp
orts

5.5 figure

The Product Life Cycle
Theory

Source: Adapted from R. Vernon

and L. T. Wells, The Economic

Environment of International

Reprinted by permission of

Pearson Education, Inc. Upper

Saddle River, N.J.

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182 Part Three Cross-Border Trade and Investment

New Trade Theory
The new trade theory began to emerge in the 1970s when a number of economists
pointed out that the ability of firms to attain economies of scale might have impor-
tant implications for international trade. 27 Economies of scale are unit cost reduc-
tions associated with a large scale of output. Economies of scale have a number of
sources, including the ability to spread fixed costs over a large volume, and the abil-
ity of large-volume producers to utilize specialized employees and equipment that
are more productive than less-specialized employees and equipment. Economies of
scale are a major source of cost reductions in many industries, from computer soft-
ware to automobiles, and from pharmaceuticals to aerospace. For example, Micro-
soft realizes economies of scale by spreading the fixed costs of developing new
versions of its Windows operating system, which runs to about $5 billion, over the
250 million or so personal computers upon which each new system is ultimately
installed. Similarly, automobile companies realize economies of scale by producing
a high volume of automobiles from an assembly line where each employee has a
specialized task.
New trade theory makes two important points: First, through its impact on econo-
mies of scale, trade can increase the variety of goods available to consumers and de-
crease the average costs of those goods. Second, in those industries where the output
required to attain economies of scale represents a significant proportion of total world
demand, the global market may be able to support only a small number of enterprises.
Thus, world trade in certain products may be dominated by countries whose firms
were first movers in their production.

INCREASING PRODUCT VARIETY AND REDUCING COSTS Imagine
first a world without trade. In industries where economies of scale are important, both
the variety of goods that a country can produce and the scale of production are limited
by the size of the market. If a national market is small, there may not be enough de-
mand to enable producers to realize economies of scale for certain products. Accord-
ingly, those products may not be produced, thereby limiting the variety of products
available to consumers. Alternatively, they may be produced, but at such low volumes
that unit costs and prices are considerably higher than they might be if economies of
scale could be realized.
Now consider what happens when nations trade with each other. Individual na-
tional markets are combined into a larger world market. As the size of the market ex-
pands due to trade, individual firms may be able to better attain economies of scale.
The implication, according to new trade theory, is that each nation may be able to
specialize in producing a narrower range of products than it would in the absence of
trade, yet by buying goods that it does not make from other countries, each nation can
simultaneously increase the variety of goods available to its consumers and lower the
costs of those goods—thus trade offers an opportunity for mutual gain even when
countries do not differ in their resource endowments or technology.
Suppose there are two countries, each with an annual market for 1 million auto-
mobiles. By trading with each other, these countries can create a combined market
for 2 million cars. In this combined market, due to the ability to better realize econo-
mies of scale, more varieties (models) of cars can be produced, and cars can be pro-
duced at a lower average cost, than in either market alone. For example, demand for
a sports car may be limited to 55,000 units in each national market, while a total out-
put of at least 100,000 per year may be required to realize significant scale economies.
Similarly, demand for a minivan may be 80,000 units in each national market, and
again a total output of at least 100,000 per year may be required to realize significant

LEARNING OBJECTIVE 2
Summarize the different
theories explaining trade
flows between nations.

LEARNING OBJECTIVE 3
Recognize why many
economists believe that
unrestricted free trade
between nations will raise
the economic welfare of
countries that participate in
a free trade system.

Economies of Scale
Cost advantages

associated with large-
scale production.

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Chapter Five International Trade Theory 183

scale economies. Faced with limited domestic market demand, firms in each nation
may decide not to produce a sports car, since the costs of doing so at such low volume
are too great. Although they may produce minivans, the cost of doing so will be higher,
as will prices, than if significant economies of scale had been attained. Once the two
countries decide to trade, however, a firm in one nation may specialize in producing
sports cars, while a firm in the other nation may produce minivans. The combined
demand for 110,000 sports cars and 160,000 minivans allows each firm to realize scale
economies. Consumers in this case benefit from having access to a product (sports
cars) that was not available before international trade and from the lower price for a
product (minivans) that could not be produced at the most efficient scale before inter-
national trade. Trade is thus mutually beneficial because it allows for the specialization
of production, the realization of scale economies, the production of a greater variety of
products, and lower prices.

ECONOMIES OF SCALE, FIRST MOVER ADVANTAGES AND THE
PATTERN OF TRADE A second theme in new trade theory is that the pattern
of trade we observe in the world economy may be the result of economies of scale and
first-mover advantages. First-mover advantages are the economic and strategic ad-
vantages that accrue to early entrants into an industry. 28 The ability to capture scale
economies ahead of later entrants, and thus benefit from a lower cost structure, is an
important first-mover advantage. New trade theory argues that for those products
where economies of scale are significant and represent a substantial proportion of
world demand, the first movers in an industry can gain a scale-based cost advantage
that later entrants find almost impossible to match. Thus, the pattern of trade that we
observe for such products may reflect first-mover advantages. Countries may domi-
nate in the export of certain goods because economies of scale are important in their
production and because firms located in those countries were the first to capture scale
economies, giving them a first-mover advantage.
For example, consider the commercial aerospace industry, where substantial
scale economies come from the ability to spread the fixed costs of developing a new
jet aircraft over a large number of sales. It has cost Airbus some $15 billion to
develop its new super-jumbo jet, the 550-seat A380. To recoup those costs and
break even, Airbus will have to sell at least 250 A380 planes. If Airbus can sell over
350 A380 planes, it will apparently be a profitable venture. Total demand over the
next 20 years for this class of aircraft is estimated to be somewhere between 400
and 600 units. Thus, the global market can probably profitably support only one
producer of jet aircraft in the super-jumbo category. It follows that the European
Union might come to dominate in the export of very large jet aircraft, primarily
because a European-based firm, Airbus, was the first to produce a super-jumbo jet
and realize scale economies. Other potential producers, such as Boeing, might be
shut out of the market because they will lack the scale economies that Airbus will
enjoy. By pioneering this market category, Airbus may have captured a first-mover
advantage based on scale economies that will be difficult for rivals to match, and
that will result in the European Union becoming the leading exporter of very large
jet aircraft. (Boeing does not believe the market to be large enough to profitably
support even one producer, hence its decision not to build a similar aircraft, and
instead focus on its super- efficient 787.)

IMPLICATIONS OF NEW TRADE THEORY New trade theory has impor-
tant implications. The theory suggests that nations may benefit from trade even when
they do not differ in resource endowments or technology. Trade allows a nation to spe-
cialize in the production of certain products, attaining scale economies and lowering

First-Mover
Advantages
Advantages accruing to
the first to enter a
market.

LEARNING OBJECTIVE 3
Recognize why many
economists believe that
unrestricted free trade
between nations will raise
the economic welfare of
countries that participate in
a free trade system.

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184 Part Three Cross-Border Trade and Investment

the costs of producing those products, while buying products that it does not produce
from other nations that specialize in the production of those products. By this mecha-
nism, the variety of products available to consumers in each nation is increased, while
the average costs of those products should fall, as should their price, freeing resources
to produce other goods and services.
The theory also suggests that a country may predominate in the export of a good
simply because it was lucky enough to have one or more firms among the first to pro-
duce that good. Because they are able to gain economies of scale, the first movers in an
industry may get a lock on the world market that discourages subsequent entry. First
movers’ ability to benefit from increasing returns creates a barrier to entry. In the
commercial aircraft industry, the fact that Boeing and Airbus are already in the indus-
try and have the benefits of economies of scale discourages new entry and reinforces
the dominance of America and Europe in the trade of midsized and large jet aircraft.
This dominance is further reinforced because global demand may not be sufficient to
profitably support another producer of midsized and large jet aircraft in the industry.
So although Japanese firms might be able to compete in the market, they have decided
not to enter the industry but to ally themselves as major subcontractors with primary
producers (e.g., Mitsubishi Heavy Industries is a major subcontractor for Boeing on
the 777 and 787 programs).
New trade theory is at variance with the Heckscher-Ohlin theory, which suggests
that a country will predominate in the export of a product when it is particularly well
endowed with those factors used intensively in its manufacture. New trade theorists
argue that the United States is a major exporter of commercial jet aircraft not because
it is better endowed with the factors of production required to manufacture aircraft,
but because one of the first movers in the industry, Boeing, was a U.S. firm. The new
trade theory is not at variance with the theory of comparative advantage. Economies
of scale increase productivity. Thus, the new trade theory identifies an important
source of comparative advantage.
This theory is quite useful in explaining trade patterns. Empirical studies seem to sup-
port the predictions of the theory that trade increases the specialization of production

The European Union may come to dominate in the export of super-jumbo jets primarily because Airbus, a European-based
firm, was the first to produce a 550-seat aircraft and realize economies of scale.

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Chapter Five International Trade Theory 185

within an industry, increases the variety of products available to consumers, and results in
lower average prices. 29 With regard to first-mover advantages and international trade, a
study by Harvard business historian Alfred Chandler suggests the existence of first-mover
advantages is an important factor in explaining the dominance of firms from certain na-
tions in specific industries. 30 The number of firms is very limited in many global indus-
tries, including the chemical industry, the heavy construction-equipment industry, the
heavy truck industry, the tire industry, the consumer electronics industry, the jet engine
industry, and the computer software industry.
Perhaps the most contentious implication of the new trade theory is the argu-
ment that it generates for government intervention and strategic trade policy. 31 New
trade theorists stress the role of luck, entrepreneurship, and innovation in giving a
firm first-mover advantages. According to this argument, the reason Boeing was the
first mover in commercial jet aircraft manufacture—rather than firms such as Great
Britain’s DeHavilland and Hawker Siddeley, or Holland’s Fokker, all of which could
have been—was that Boeing was both lucky and innovative. One way Boeing was
lucky is that DeHavilland’s Comet jet airliner, introduced two years earlier than
Boeing’s first jet airliner, the 707, was found to be full of serious technological flaws.
Had DeHavilland not made serious technological mistakes, Great Britain might
have become the world’s leading exporter of commercial jet aircraft. Boeing’s inno-
vativeness was demonstrated by its independent development of the technological
know-how required to build a commercial jet airliner. Several new trade theorists
have pointed out, however, that Boeing’s R&D was largely paid for by the U.S. gov-
ernment; the 707 was a spin-off from a government-funded military program (the
entry of Airbus into the industry was also supported by significant government sub-
sidies). Herein is a rationale for government intervention; by the sophisticated and
judicious use of subsidies, could a government increase the chances of its domestic
firms becoming first movers in newly emerging industries, as the U.S. government
apparently did with Boeing (and the European Union did with Airbus)? If this is
possible, and the new trade theory suggests it might be, we have an economic ratio-
nale for a proactive trade policy that is at variance with the free trade prescriptions
of the trade theories we have reviewed so far. We will consider the policy implica-
tions of this issue in Chapter 6.

National Competitive Advantage:

Porter’s Diamond
In 1990 Michael Porter of the Harvard Business School published the results of an
intensive research effort that attempted to determine why some nations succeed and
others fail in international competition. 32 Porter and his team looked at 100 indus-
tries in 10 nations. Like the work of the new trade theorists, Porter’s work was driven
by a belief that existing theories of international trade told only part of the story. For
Porter, the essential task was to explain why a nation achieves international success in
a particular industry. Why does Japan do so well in the automobile industry? Why
does Switzerland excel in the production and export of precision instruments and
pharmaceuticals? Why do Germany and the United States do so well in the chemical
industry? These questions cannot be answered easily by the Heckscher-Ohlin theory,
and the theory of comparative advantage offers only a partial explanation. The theory
of comparative advantage would say that Switzerland excels in the production and
export of precision instruments because it uses its resources very productively in
these industries. Although this may be correct, this does not explain why Switzerland

LEARNING OBJECTIVE 4
Explain the arguments of
those who maintain that

government can play a
proactive role in promoting

national competitive
advantage in certain

industries.

LEARNING OBJECTIVE 2
Summarize the different
theories explaining trade
flows between nations.

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186 Part Three Cross-Border Trade and Investment

is more productive in this industry than Great Britain, Germany, or Spain. Porter
tries to solve this puzzle.
Porter theorizes that four broad attributes of a nation shape the environment in
which local firms compete, and these attributes promote or impede the creation of
competitive advantage (see Figure 5.6). These attributes are

• Factor endowments —a nation’s position in factors of production such as skilled
labor or the infrastructure necessary to compete in a given industry.

• Demand conditions —the nature of home demand for the industry’s product or
service.

• Relating and supporting industries —the presence or absence of supplier industries
and related industries that are internationally competitive.

• Firm strategy, structure, and rivalry —the conditions governing how companies are
created, organized, and managed and the nature of domestic rivalry.

Porter speaks of these four attributes as constituting the diamond. He argues that firms
are most likely to succeed in industries or industry segments where the diamond is most

favorable. He also argues that the diamond is a mutu-
ally reinforcing system. The effect of one attribute
is contingent on the state of others. For example,
Porter argues favorable demand conditions will not
result in competitive advantage unless the state of
rivalry is sufficient to cause firms to respond to them.

Porter maintains that two additional variables
can influence the national diamond in important
ways: chance and government. Chance events, such
as major innovations, can reshape industry struc-
ture and provide the opportunity for one nation’s
firms to supplant another’s. Government, by its
choice of policies, can detract from or improve na-
tional advantage. For example, regulation can alter
home demand conditions, antitrust policies can in-
fluence the intensity of rivalry within an industry,
and government investments in education can
change factor endowments.

Demand
conditions

Factor
endowments

Related and
supporting
industries

Firm strategy,
structure, and

rivalry

figure 5.6

Determinants of
National Competitive

Advantage: Porter’s
Diamond

Source: Reprinted by permission of

the Harvard Business Review . “The

Competitive Advantage of Nations”

by Michael E. Porter, March–April

The President and Fellows of

A n o t h e r P e r s p e c t i v e

North Dakota: Oil Capital of the Plains?
When you think “North Dakota,” what comes to mind? Per-
haps you think endless fields of winter wheat, the Minot Air
Force Base, or the Coen brothers’ award-winning film,
Fargo . You’re probably unlikely to think oil—but if you did,
you’d be right. Thanks to recent technology improvements,
oil has become North Dakota’s fastest-growing industry and
an important new factor endowment for the state. In 2009, oil
production doubled in North Dakota, rendering it the fourth-
largest oil producer in the United States. If estimates are
accurate, some observers believe North Dakota could out-
perform Alaska in oil production by 2019. (Ben Castleman,
“Oil Industry Booms—in North Dakota,” The Wall Street
Journal, February 26, 2010, http://online.wsj.com)

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Chapter Five International Trade Theory 187

FACTOR E N DOWM E NTS Factor en-
dowments lie at the center of the Heckscher-
Ohlin theory. While Porter does not propose
anything radically new, he does analyze the char-
acteristics of factors of production. He recog-
nizes hierarchies among factors, distinguishing
between basic factors (e.g., natural resources, cli-
mate, location, and demographics) and advanced
factors (e.g., communication infrastructure, so-
phisticated and skilled labor, research facilities,
and technological know-how). He argues that
advanced factors are the most significant for
competitive advantage. Unlike the naturally en-
dowed basic factors, advanced factors are a prod-
uct of investment by individuals, companies, and
governments. Thus, government investments in
basic and higher education, by improving the
general skill and knowledge level of the popula-
tion and by stimulating advanced research at
higher education institutions, can upgrade a
nation’s advanced factors.
The relationship between advanced and basic factors is complex. Basic factors can
provide an initial advantage that is subsequently reinforced and extended by invest-
ment in advanced factors. Conversely, disadvantages in basic factors can create pres-
sures to invest in advanced factors. An obvious example of this phenomenon is Japan,
a country that lacks arable land and mineral deposits and yet through investment has
built a substantial endowment of advanced factors. Porter notes that Japan’s large pool
of engineers (reflecting a much higher number of engineering graduates per capita
than almost any other nation) has been vital to Japan’s success in many manufacturing
industries.

DEMAND CONDITIONS Porter emphasizes the role home demand plays in
upgrading competitive advantage. Firms are typically most sensitive to the needs of
their closest customers. Thus, the characteristics of home demand are particularly im-
portant in shaping the attributes of domestically made products and in creating pres-
sures for innovation and quality. Porter argues that a nation’s firms gain competitive
advantage if their domestic consumers are sophisticated and demanding. Such con-
sumers pressure local firms to meet high standards of product quality and to produce
innovative products. Porter notes that Japan’s sophisticated and knowledgeable buyers
of cameras helped stimulate the Japanese camera industry to improve product quality
and to introduce innovative models. A similar example can be found in the wireless
telephone equipment industry, where sophisticated and demanding local customers in
Scandinavia helped push Nokia of Finland and Ericsson of Sweden to invest in cellular
phone technology long before demand for cellular phones took off in other developed
nations. The case of Nokia is reviewed in more depth in the accompanying Manage-
ment Focus.

RELATED AND SUPPORTING INDUSTRIES The third broad attribute
of national advantage in an industry is the presence of suppliers or related industries
that are internationally competitive. The benefits of investments in advanced factors
of production by related and supporting industries can spill over into an industry,

A n o t h e r P e r s p e c t i v e

Factor Endowments: A Quiz
One of the most significant factor endowments is educa-
tion, with important measures being literacy rate and the
literacy rate gap between the genders. Which of the fol-
lowing countries do you think has the largest literacy gap
between males and females? (a) Iraq, (b) Rwanda,
(c) Chile, (d) India.
The answer may surprise you. It’s not Iraq, although in
nearly all countries of the Middle East, men are more likely
than women to be literate. With 74 percent literacy overall,
Iraq has a nearly 20-point gap between males and females.
Nor is it Rwanda, with a 12-point gap and a 70 percent lit-
eracy rate overall. And it certainly isn’t Chile, with its
96 percent literacy rate and less than a 1-point gap be-
tween the sexes. It is India, with an overall adult literacy
rate of 61 percent and a gap of nearly 26 points between
males and females. (U.S. Central Intelligence Agency,
World Factbook 2010, www.cia.gov)

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188 Part Three Cross-Border Trade and Investment

thereby helping it achieve a strong competitive position internationally. Swedish
strength in fabricated steel products (e.g., ball bearings and cutting tools) has drawn
on strengths in Sweden’s specialty steel industry. Technological leadership in the U.S.
semiconductor industry provided the basis for U.S. success in personal computers and
several other technically advanced electronic products. Similarly, Switzerland’s success
in pharmaceuticals is closely related to its previous international success in the techno-
logically related dye industry.

M a n a g e m e n t F O C U S

The Rise of Finland’s Nokia

The wireless phone market is one of the great growth sto-
ries of the last decade. Starting from a very low base in
1990, annual global sales of wireless phones surged to
reach about 1.2 billion units in 2009. By the end of 2009, the
number of wireless subscriber accounts worldwide was
around 4.5 billion, up from less than 10 million in 1990.
Nokia is one of the dominant players in the world market
for mobile phones with a 37 percent share of the market in
2008. Nokia’s roots are in Finland, not normally a country
that comes to mind when one talks about leading-edge
technology companies. In the 1980s, Nokia was a rambling
Finnish conglomerate with activities that embraced tire
manufacturing, paper production, consumer electronics,
and telecommunications equipment. By the early 2000s it
had transformed itself into a focused telecommunications
equipment manufacturer with a global reach. How has this
former conglomerate emerged to take a global leadership
position in wireless telecommunications equipment? Much
of the answer lies in the history, geography, and political
economy of Finland and its Nordic neighbors.
In 1981 the Nordic nations cooperated to create the
world’s first international wireless telephone network.
They had good reason to become pioneers: It cost far too
much to lay a traditional wire-line telephone service in
those sparsely populated and inhospitably cold countries.
The same features made telecommunications all the more
valuable: People driving through the Arctic winter and
owners of remote northern houses needed a telephone to
summon help if things went wrong. As a result, Sweden,
Norway, and Finland became the first nations in the world
to take wireless telecommunications seriously. They found,
for example, that although it cost up to $800 per subscriber
to bring a traditional wire-line service to remote locations,
the same locations could be linked by wireless cellular for
only $500 per person. As a consequence, 12 percent of
people in Scandinavia owned cellular phones by 1994,
compared with less than 6 percent in the United States, the
world’s second most developed market. This lead contin-
ued over the next decade. By 2008, 90 percent of the popu-

lation in Finland owned a wireless phone, compared with
70 percent in the United States.
Nokia, a longtime telecommunications equipment sup-
plier, was well positioned to take advantage of this devel-
opment from the start, but other forces were also at work
to help Nokia develop its competitive edge. Unlike virtually
every other developed nation, Finland has never had a
national telephone monopoly. Instead, the country’s tele-
phone services have long been provided by about
50 autonomous local telephone companies whose elected
boards set prices by referendum (which naturally means
low prices). This army of independent and cost-conscious
telephone service providers prevented Nokia from taking
anything for granted in its home country. With typical
Finnish pragmatism, its customers were willing to buy from
the lowest-cost supplier, whether that was Nokia, Ericsson,
Motorola, or some other company. This situation con-
trasted sharply with that prevailing in most developed na-
tions until the late 1980s and early 1990s, where domestic
telephone monopolies typically purchased equipment from
a dominant local supplier or made it themselves. Nokia re-
sponded to this competitive pressure by doing everything
possible to drive down its manufacturing costs while stay-
ing at the leading edge of wireless technology.
The consequences of these forces are clear. Nokia is
now a leader in digital wireless technology. Many now re-
gard Finland as one of the lead markets for wireless tele-
phone services. If you want to see the future of wireless, you
don’t go to New York or San Francisco; you go to Helsinki,
where Finns use their wireless handsets not just to talk to
each other or browse the Web, but also to control house-
hold heating and lighting systems, or purchase Coke from a
wireless-enabled vending machine. Nokia has gained this
lead because Scandinavia started switching to digital
technology five years before the rest of the world.

Sources: “Lessons from the Frozen North,” The Economist , October 8, 1994,
pp. 76–77; “A Finnish Fable,” The Economist , October 14, 2000; D. O’Shea
and K. Fitchard, “The First 3 Billion Is Always the Hardest,” Wireless
Review 22 (September 2005), pp. 25–31; P. Taylor, “Big Names Dominate in
Mobile Phones,” Financial Times , September 29, 2006, p. 26; and Nokia
Web site at www.nokia.com.

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Chapter Five International Trade Theory 189

One consequence of this process is that successful industries within a country tend
to be grouped into clusters of related industries. This was one of the most pervasive
findings of Porter’s study. One such cluster Porter identified was in the German textile
and apparel sector, which included high-quality cotton, wool, synthetic fibers, sewing
machine needles, and a wide range of textile machinery. Such clusters are important
because valuable knowledge can flow between the firms within a geographic cluster,
benefiting all within that cluster. Knowledge flows occur when employees move be-
tween firms within a region and when national industry associations bring employees
from different companies together for regular conferences or workshops. 33

FIRM STRATEGY, STRUCTURE, AND RIVALRY The fourth broad attri-
bute of national competitive advantage in Porter’s model is the strategy, structure, and
rivalry of firms within a nation. Porter makes two important points here. First, differ-
ent nations are characterized by different management ideologies, which either help
them or do not help them to build national competitive advantage. For example,
Porter noted the predominance of engineers in top management at German and
Japanese firms. He attributed this to these firms’ emphasis on improving manufactur-
ing processes and product design. In contrast, Porter noted a predominance of people
with finance backgrounds leading many U.S. firms. He linked this to U.S. firms’ lack
of attention to improving manufacturing processes and product design. He argued
that the dominance of finance led to an overemphasis on maximizing short-term
financial returns. According to Porter, one consequence of these different manage-
ment ideologies was a relative loss of U.S. competitiveness in those engineering-based
industries where manufacturing processes and product design issues are all-important
(e.g., the automobile industry).
Porter’s second point is that there is a strong association between vigorous do-
mestic rivalry and the creation and persistence of competitive advantage in an in-
dustry. Vigorous domestic rivalry induces firms to look for ways to improve
efficiency, which makes them better international competitors. Domestic rivalry
creates pressures to innovate, to improve quality, to reduce costs, and to invest in
upgrading advanced factors. All this helps to create world-class competitors. Porter
cites the case of Japan:

Nowhere is the role of domestic rivalry more evident than in Japan, where it is
all-out warfare in which many companies fail to achieve profitability. With goals
that stress market share, Japanese companies engage in a continuing struggle to
outdo each other. Shares fluctuate markedly. The process is prominently covered
in the business press. Elaborate rankings measure which companies are most
popular with university graduates. The rate of new product and process develop-
ment is breathtaking. 34

A similar point about the stimulating effects of strong domestic competition can be
made with regard to the rise of Nokia of Finland to global preeminence in the market
for cellular telephone equipment. For details, see the Management Focus.

EVALUATING PORTER’S THEORY Porter contends that the degree to
which a nation is likely to achieve international success in a certain industry is a
function of the combined impact of factor endowments, domestic demand condi-
tions, related and supporting industries, and domestic rivalry. He argues that the
presence of all four components is usually required for this diamond to boost com-
petitive performance (although there are exceptions). Porter also contends that gov-
ernment can influence each of the four components of the diamond—either

LEARNING OBJECTIVE 4
Explain the arguments of
those who maintain that
government can play a
proactive role in promoting
national competitive
advantage in certain
industries.

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190 Part Three Cross-Border Trade and Investment

positively or negatively. Factor endowments can be affected by subsidies, policies
toward capital markets, policies toward education, and so on. Government can shape
domestic demand through local product standards or with regulations that mandate
or influence buyer needs. Government policy can influence supporting and related
industries through regulation and influence firm rivalry through such devices as
capital market regulation, tax policy, and antitrust laws.
If Porter is correct, we would expect his model to predict the pattern of interna-
tional trade that we observe in the real world. Countries should be exporting products
from those industries where all four components of the diamond are favorable, while
importing in those areas where the components are not favorable. Is he correct? We
simply do not know. Porter’s theory has not been subjected to detailed empirical test-
ing. Much about the theory rings true, but the same can be said for the new trade
theory, the theory of comparative advantage, and the Heckscher-Ohlin theory. It may
be that each of these theories, which complement each other, explains something
about the pattern of international trade.

Focus on Managerial Implications

Why does all this matter for business? There are at least three main implications for
international businesses of the material discussed in this chapter: location implica-
tions, first-mover implications, and policy implications.

Location
Underlying most of the theories we have discussed is the notion that different coun-
tries have particular advantages in different productive activities. Thus, from a profit
perspective, it makes sense for a firm to disperse its productive activities to those
countries where, according to the theory of international trade, they can be per-
formed most efficiently. If design can be performed most efficiently in France, that is
where design facilities should be located; if the manufacture of basic components can
be performed most efficiently in Singapore, that is where they should be manufac-
tured; and if final assembly can be performed most efficiently in China, that is where
final assembly should be performed. The result is a global web of productive activi-
ties, with different activities being performed in different locations around the globe
depending on considerations of comparative advantage, factor endowments, and the
like. If the firm does not do this, it may find itself at a competitive disadvantage rela-
tive to firms that do.
Consider the production of a laptop computer, a process with four major stages:
(1) basic research and development of the product design, (2) manufacture of standard
electronic components (e.g., memory chips), (3) manufacture of advanced components
(e.g., flat-top color display screens and microprocessors), and (4) final assembly. Basic
R&D requires a pool of highly skilled and educated workers with good backgrounds
in microelectronics. The two countries with a comparative advantage in basic micro-
electronics R&D and design are Japan and the United States, so most producers of
laptop computers locate their R&D facilities in one, or both, of these countries.
(Apple, IBM, Motorola, Texas Instruments, Toshiba, and Sony all have major R&D
facilities in both Japan and the United States.)

LEARNING OBJECTIVE 5
Understand the important
implications that
international trade theory
holds for business practice.

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Chapter Five International Trade Theory 191

The manufacture of standard electronic components is a capital-intensive process
requiring semiskilled labor, and cost pressures are intense. The best locations for such
activities today are places such as Taiwan, Malaysia, and South Korea. These coun-
tries have pools of relatively skilled, moderate-cost labor. Thus, many producers of
laptop computers have standard components, such as memory chips, produced at
these locations.
The manufacture of advanced components such as microprocessors is a capital-
intensive process requiring skilled labor. Because cost pressures are not so intense at
this stage, these components can be—and are—manufactured in countries with
high labor costs that also have pools of highly skilled labor (e.g. Japan and the
United States).
Finally, assembly is a relatively labor-intensive process requiring only low-skilled
labor, and cost pressures are intense. As a result, final assembly may be carried out in
a country such as Mexico, which has an abundance of low-cost, low-skilled labor. A
laptop computer produced by a U.S. manufacturer may be designed in California,
have its standard components produced in Taiwan and Singapore, its advanced com-
ponents produced in Japan and the United States, its final assembly in Mexico, and be
sold in the United States or elsewhere in the world. By dispersing production activi-
ties to different locations around the globe, the U.S. manufacturer is taking advan-
tage of the differences between countries identified by the various theories of
international trade.

First-Mover Advantages
According to the new trade theory, firms that establish a first-mover advantage with
regard to the production of a particular new product may subsequently dominate
global trade in that product. This is particularly true in industries where the global
market can profitably support only a limited number of firms, such as the aerospace
market, but early commitments also seem to be important in less concentrated indus-
tries such as the market for cellular telephone equipment (see the Management Focus
on Nokia). For the individual firm, the clear message is that it pays to invest substan-
tial financial resources in trying to build a first-mover, or early-mover, advantage, even
if that means several years of losses before a new venture becomes profitable. The idea
is to preempt the available demand, gain cost advantages related to volume, build an
enduring brand ahead of later competitors, and, consequently, establish a long-term
sustainable competitive advantage. Although the details of how to achieve this are be-
yond the scope of this book, many publications offer strategies for exploiting first-
mover advantages, and for avoiding the traps associated with pioneering a market
(first-mover disadvantages). 35

Government Policy
The theories of international trade also matter to international businesses because
firms are major players on the international trade scene. Business firms produce ex-
ports, and business firms import the products of other countries. Because of their
pivotal role in international trade, businesses can exert a strong influence on govern-
ment trade policy, lobbying to promote free trade or trade restrictions. The theories of
international trade claim that promoting free trade is generally in the best interests of
a country, although it may not always be in the best interest of an individual firm.
Many firms recognize this and lobby for open markets.
For example, when the U.S. government announced its intention to place a tariff on
Japanese imports of liquid-crystal display (LCD) screens in the 1990s, IBM and Apple
Computer protested strongly. Both IBM and Apple pointed out that (1) Japan was the
lowest-cost source of LCD screens, (2) they used these screens in their own laptop

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192 Part Three Cross-Border Trade and Investment

computers, and (3) the proposed tariff, by increasing the cost of LCD screens, would
increase the cost of laptop computers produced by IBM and Apple, thus making them
less competitive in the world market. In other words, the tariff, designed to protect
U.S. firms, would be self-defeating. In response to these pressures, the U.S. govern-
ment reversed its posture.
Unlike IBM and Apple, however, businesses do not always lobby for free trade. In
the United States, for example, restrictions on imports of steel are the result of direct
pressure by U.S. firms on the government. In some cases, the government has re-
sponded to pressure by getting foreign companies to agree to “voluntary” restrictions
on their imports, using the implicit threat of more comprehensive formal trade barri-
ers to get them to adhere to these agreements (historically, this has occurred in the
automobile industry). In other cases, the government used what are called “antidump-
ing” actions to justify tariffs on imports from other nations (these mechanisms will be
discussed in detail in the next chapter).
As predicted by international trade theory, many of these agreements have been
self-defeating, such as the voluntary restriction on machine tool imports agreed to in
1985. Due to limited import competition from more efficient foreign suppliers, the
prices of machine tools in the United States rose to higher levels than would have
prevailed under free trade. Because machine tools are used throughout the manufac-
turing industry, the result was to increase the costs of U.S. manufacturing in general,
creating a corresponding loss in world market competitiveness. Shielded from interna-
tional competition by import barriers, the U.S. machine tool industry had no incentive
to increase its efficiency. Consequently, it lost many of its export markets to more ef-
ficient foreign competitors. Because of this misguided action, the U.S. machine tool
industry shrunk during the period when the agreement was in force. For anyone
schooled in international trade theory, this was not surprising. 36 A similar scenario
unfolded in the U.S. steel industry, where tariff barriers erected by the government in
2001 raised the cost of steel to important U.S. users, such as automobile companies
and appliance makers, making their products more uncompetitive.
Finally, Porter’s theory of national competitive advantage also contains policy im-
plications. Porter’s theory suggests that it is in the best interest of business for a firm
to invest in upgrading advanced factors of production; for example, to invest in bet-
ter training for its employees and to increase its commitment to research and devel-
opment. It is also in the best interests of business to lobby the government to adopt
policies that have a favorable impact on each component of the national diamond.
Thus, according to Porter, businesses should urge government to increase invest-
ment in education, infrastructure, and basic research (since all these enhance ad-
vanced factors) and to adopt policies that promote strong competition within
domestic markets (since this makes firms stronger international competitors, ac-
cording to Porter’s findings).

free trade, p. 163
new trade theory, p. 165
mercantilism, p. 165
zero-sum game, p. 167

absolute advantage, p. 167
constant returns to specialization,
p. 173
factor endowments, p. 178

economies of scale, p. 182
first-mover advantages, p. 183

Key Terms

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Chapter Five International Trade Theory 193

Summary

This chapter has reviewed a number of theories that
explain why it is beneficial for a country to engage in
international trade and has explained the pattern of
international trade observed in the world economy.
We have seen how the theories of Smith, Ricardo,
and Heckscher-Ohlin all make strong cases for un-
restricted free trade. In contrast, the mercantilist
doctrine and, to a lesser extent, the new trade theory
can be interpreted to support government interven-
tion to promote exports through subsidies and to
limit imports through tariffs and quotas.
In explaining the pattern of international trade,
the second objective of this chapter, we have seen
that with the exception of mercantilism, which is
silent on this issue, the different theories offer largely
complementary explanations. Although no one the-
ory may explain the apparent pattern of international
trade, taken together, the theory of comparative
advantage, the Heckscher-Ohlin theory, the product
life-cycle theory, the new trade theory, and Porter’s
theory of national competitive advantage do suggest
which factors are important. Comparative advantage
tells us that productivity differences are important;
Heckscher-Ohlin tells us that factor endowments
matter; the product life-cycle theory tells us that
where a new product is introduced is important; the
new trade theory tells us that increasing returns to
specialization and first-mover advantages matter; and
Porter tells us that all these factors may be important
insofar as they impact the four components of the
national diamond. The chapter made these major
points:

1. Mercantilists argued that it was in a country’s
best interests to run a balance-of-trade surplus.
They viewed trade as a zero-sum game, in
which one country’s gains cause losses for other
countries.

2. The theory of absolute advantage suggests that
countries differ in their ability to produce
goods efficiently. The theory suggests that a
country should specialize in producing goods
in areas where it has an absolute advantage and
import goods in areas where other countries
have absolute advantages.

3. The theory of comparative advantage suggests
that it makes sense for a country to specialize in
producing those goods that it can produce
most efficiently, while buying goods that it can

produce relatively less efficiently from other
countries—even if that means buying goods
from other countries that it could produce
more efficiently itself.

4. The theory of comparative advantage suggests
that unrestricted free trade brings about
increased world production; that is, that trade
is a positive-sum game.

5. The theory of comparative advantage also
suggests that opening a country to free trade
stimulates economic growth, which creates
dynamic gains from trade. The empirical
evidence seems to be consistent with this claim.

6. The Heckscher-Ohlin theory argues that the
pattern of international trade is determined by
differences in factor endowments. It predicts
that countries will export those goods that
make intensive use of locally abundant factors
and will import goods that make intensive use
of factors that are locally scarce.

7. The product life-cycle theory suggests that
trade patterns are influenced by where a new
product is introduced. In an increasingly
integrated global economy, the product life-
cycle theory seems to be less predictive than it
once was.

8. New trade theory states that trade allows a
nation to specialize in the production of certain
goods, attaining scale economies and lowering
the costs of producing those goods, while
buying goods that it does not produce from
other nations that are similarly specialized. By
this mechanism, the variety of goods available
to consumers in each nation is increased, while
the average costs of those goods should fall.

9. New trade theory also states that in those
industries where substantial economies of scale
imply that the world market will profitably
support only a few firms, countries may
predominate in the export of certain products
simply because they had a firm that was a first
mover in that industry.

10. Some new trade theorists have promoted the
idea of strategic trade policy. The argument is
that government, by the sophisticated and
judicious use of subsidies, might be able to
increase the chances of domestic firms becoming
first movers in newly emerging industries.

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194 Part Three Cross-Border Trade and Investment

11. Porter’s theory of national competitive advantage
suggests that the pattern of trade is influenced
by four attributes of a nation: (a) factor
endowments, (b) domestic demand conditions,
(c) relating and supporting industries, and
(d) firm strategy, structure, and rivalry.

12. Theories of international trade are important
to an individual business firm primarily because

they can help the firm decide where to locate
its various production activities.

13. Firms involved in international trade can and
do exert a strong influence on government
policy toward trade. By lobbying government,
business firms can promote free trade or trade
restrictions.

Critical Thinking and Discussion Questions

1. Mercantilism is a bankrupt theory that has no
place in the modern world. Discuss.

2. Is free trade fair? Discuss.
3. Unions in developed nations often oppose

imports from low-wage countries and advocate
trade barriers to protect jobs from what they
often characterize as “unfair” import
competition. Is such competition “unfair”? Do
you think that this argument is in the best
interests of ( a ) the unions, ( b ) the people they
represent, and/or ( c ) the country as a whole?

4. What are the potential costs of adopting a free
trade regime? Do you think governments should
do anything to reduce these costs? What?

5. Reread the Country Focus “Is China a Neo-
mercantilist Nation?”

a. Do you think China is pursing an economic
policy that can be characterized as neo-
mercantilist?

b. What should the United States, and other
countries, do about this?

6. Reread the Country Focus “Moving U.S. White-
Collar Jobs Offshore.”

a. Who benefits from the outsourcing of skilled
white-collar jobs to developing nations? Who
are the losers?

b. Will developing nations like the United States
suffer from the loss of high-skilled and high-
paying jobs?

c. Is there a difference between the transference
of high-paying white-collar jobs, such as
computer programming and accounting, to
developing nations and low-paying blue-collar
jobs? If so, what is the difference, and should
government do anything to stop the flow of
white-collar jobs out of the country to
countries such as India?

7. Drawing upon the new trade theory and Porter’s
theory of national competitive advantage, outline
the case for government policies that would
build national competitive advantage in
biotechnology. What kinds of policies would you
recommend that the government adopt? Are
these policies at variance with the basic free
trade philosophy?

8. The world’s poorest countries are at a
competitive disadvantage in every sector of their
economies. They have little to export. They have
no capital; their land is of poor quality; they
often have too many people given available work
opportunities; and they are poorly educated.
Free trade cannot possibly be in the interests of
such nations! Discuss.

Use the globalEDGE Resource Desk (http://
globalEDGE.msu.edu/resourcedesk/) to complete
the following exercises:

1. You work for a telecommunications company
and your current project is to determine the five
African countries that, in your estimation, should

have an advantage in telecommunications
infrastructure. Use a resource that tracks statistics
on economic factors such as Internet use of each
country. Develop a list and brief report on the
top five African countries in telecommunications
infrastructure. Were you surprised by any
countries listed? Why (or, why not)?

Research Task http://globalEDGE.msu.edu

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Chapter Five International Trade Theory 195

2. Your coffee firm is seeking new locations to
source coffee from to sustain its growth as it
internationalizes. Currently, your company only
purchases green coffee beans from South
America and is hoping to begin purchasing
coffee from the Central American countries of
Costa Rica, El Salvador, Guatemala, Honduras,

and Panama. Applying the most current
information from FAOSTAT, a UN agency Web
site that gathers data on food and agricultural
trade flows, determine which three countries
have the highest export value of green coffee as
well as growth of export value over the most
recent year of data available.

Logitech

Best known as one of the world’s largest producers of com-
puter mice, Logitech is in many ways the epitome of the mod-
ern global corporation. Founded in 1981 in Apples, Switzerland,
by two Italians and a Swiss, the company now generates
annual sales of more than $2.2 billion, most from products
such as mice, keyboards and low-cost video-cams. Logitech
made its name as a technological innovator in the highly
competitive business of personal computer peripherals. It
was the first company to introduce a mouse that used infrared
tracking, rather than a tracking ball, and the first to introduce
the wireless mouse and keyboard. Logitech is differentiated
from competitors by its continuing innovation, its high brand
recognition, and strong retail presence. Less obvious to con-
sumers, but equally important, has been the way the company
has configured its global value chain to lower production
costs while maintaining the value of those assets that lead to
differentiation.
Logitech still undertakes basic R&D work (primarily soft-
ware programming) in Switzerland where it has several hun-
dred employees. The company is still legally Swiss, but most
of the corporate functions are run out of offices in Fremont,
California, close to many of America’s high-technology enter-
prises, where it has more than 500 employees. Some R&D
work (again, primarily software programming) is also carried
out in Fremont. Most significantly though, Fremont is the
headquarters for the company’s global marketing, finance,
and logistics operations. The ergonomic design of Logitech’s
products—their look and feel—is done in Ireland by an out-
side design firm. Most of Logitech’s products are manufac-
tured in Asia.
Logitech’s expansion into Asian manufacturing began in
the late 1980s when it opened a factory in Taiwan. At the time,
most of its mice were produced in the United States. Logitech
was trying to win two of the most prestigious OEM customers—
Apple Computer and IBM. Both bought their mice from Alps,
a large Japanese firm that supplied Microsoft. To attract

discerning customers such as Apple, Logitech not only
needed the capacity to produce at high volume and low cost,
bit it also had to offer a better-designed product. The solution:
manufacture in Taiwan. Cost was a factor in the decision, but
it was not as significant as might be expected, since direct
labor accounted for only 7 percent of the cost of Logitech’s
mouse. Taiwan offered a well-developed supply base for
parts, qualified people, and a rapidly expanding local com-
puter industry. As an inducement to fledgling innovators,
Taiwan provided space in its Hsinchu Science and Industrial
Park for the modest fee of $200,000. Sizing this up as a deal
that was too good to pass up, Logitech signed the lease. Soon
afterward, Logitech won the OEM contract with Apple. The
Taiwanese factory was soon outproducing Logitech’s U.S.
facility. After the Apple contract, Logitech’s other OEM busi-
ness started being served from Taiwan; the plant’s total
capacity increased to 10 million mice per year.
By the late 1990s, Logitech needed more production ca-
pacity. This time it turned to China. A wide variety of the com-
pany’s retail products are now made there. Take one of
Logitech’s biggest sellers, a wireless infrared mouse called
Wanda. The mouse itself is assembled in Suzhou, China, in a
factory that Logitech owns. The factory employs 4,000 people,
mostly young women such as Wang Yan, an 18-year-old em-
ployee from the impoverished rural province of Anhui. She is
paid $75 a month to sit all day at a conveyer belt plugging
three tiny bits of metal into circuit boards. She does this about
2,000 times each day. The mouse Wang Yan helps assemble
sells to American consumers for about $40. Of this, Logitech
takes about $8, which is used to fund R&D, marketing, and
corporate overhead. What remains from the $8 is the profit
attributable to Logitech’s shareholders. Distributors and re-
tailers around the world take a further $15. Another $14 goes
to the suppliers that make Wanda’s parts. For example, a
Motorola plant in Malaysia makes the mouse’s chips and
another American company, Agilent Technologies, supplies

closing case

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196 Part Three Cross-Border Trade and Investment

the optical sensors from a plant in the Philippines. That leaves
just $3 for the Chinese factory, which is used to cover wages,
power, transport, and other overhead costs.
Logitech is not alone in exploiting China to manufacture
products. According to China’s Ministry of Commerce, foreign
companies account for three-quarters of China’s high-tech
exports. China’s top 10 exporters include American compa-
nies with Chinese operations, such as Motorola and Seagate
Technology, a maker of disk drives for computers. Intel now
produces some 50 million chips a year in China, the majority
of which end up in computers and other goods that are ex-
ported to other parts of Asia, or back to the United States. Yet
Intel’s plant in Shanghai doesn’t really make chips; it tests
and assembles chips from silicon wafers made in Intel plants
abroad, mostly in the United States. China adds less than
5 percent of the value. The U.S. operations of Intel generate
the bulk of the value and profits.

Sources: V. K. Jolly and K. A. Bechler, “Logitech: The Mouse that
Roared,” Planning Review 20, no. 6 (1992), pp. 20–34; K. Guerrino,
“Lord of the Mice,” Chief Executive , July 2003, pp. 42–44; A. Higgins,
“As China Surges, It Also Proves a Buttress to American Strength,”
The Wall Street Journal , January 30, 2004, pp. A1, A8; J. Fox, “Where
Is Your Job Going?” Fortune , November 24, 2003, pp. 84–88; and
R. Wray, “Logitech Cuts 500 Jobs and Abandons Targets,”
The Guardian , January 7, 2009, p. 28.

Case Discussion Questions
1. In a world without trade, what would happen to the costs

that American consumers would have to pay for
Logitech’s products?

2. Explain how trade lowers the costs of making computer
peripherals such as mice and keyboards.

3. Use the theory of comparative advantage to explain the
way in which Logitech has configured its global
operations. Why does the company manufacture in China
and Taiwan, undertake basic R&D in California and
Switzerland, design products in Ireland, and coordinate
marketing and operations from California?

4. Who creates more value for Logitech—the 650 people it
employs in California and Switzerland, or the 4,000
employees at its Chinese factory? What are the
implications of this observation for the argument that free
trade is beneficial?

5. Why do you think the company decided to shift its
corporate headquarters from Switzerland to Fremont?

6. To what extent can Porter’s diamond help explain the
choice of Taiwan as a major manufacturing site for
Logitech?

7. Why do you think China is now a favored location for so
much high-technology manufacturing activity? How will
China’s increasing involvement in global trade help that
country? How will it help the world’s developed
economies? What potential problems are associated with
moving work to China?

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Aa p p e n d i x

Chapter Five International Trade Theory 197

International trade involves the sale of goods and services to residents in other coun-
tries (exports) and the purchase of goods and services from residents in other countries
(imports). A country’s balance-of-payments accounts keep track of the payments to
and receipts from other countries for a particular time period. These include payments
to foreigners for imports of goods and service, and receipts from foreigners for goods
and services exported to them. A summary copy of the U.S. balance-of-payments
accounts for 2008 is given in Table A.1. Any transaction resulting in a payment to
other countries is entered in the balance-of-payments accounts as a debit and given a
negative (2) sign. Any transaction resulting in a receipt from other countries is entered
as a credit and given a positive (1) sign. In this appendix we briefly describe the form
of the balance-of-payments accounts, and we discuss whether a current account defi-
cit, often a cause of much concern in the popular press, is something to worry about.

Balance of Payments Accounts
Balance-of-payments accounts are divided into three main sections: the current account,
the capital account, and the financial account (to confuse matters, what is now called the
capital account was until recently part of the current account, and the financial account
use to be called the capital account). The current account records transactions that
pertain to three categories, all of which can be seen in Table A.1. The first category, goods ,
refers to the export or import of physical goods (e.g., agricultural foodstuffs, autos, com-
puters, chemicals). The second category is the export or import of services (e.g., intangi-
ble products such as banking and insurance services). The third category, income receipts
and payments , refers to income from foreign investments and payments that have to be
made to foreigners investing in a country. For example, if a U.S. citizen owns a share of
a Finnish company and receives a dividend payment of $5, that payment shows up on
the U.S. current account as the receipt of $5 of investment income. Also included in the
current account are unilateral current transfers, such as U.S. government grants to
foreigners (including foreign aid), and private payments to foreigners (such as when a
foreign worker in the United States sends money to his or her home country).

International Trade and the

Balance of Payments

Balance-of-
Payments Accounts
National accounts that
track both payments to
and receipts from
foreigners.

Current Account
In the balance of
payments, records
transactions involving the
export or import of goods
and services.

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198 Part Three Cross-Border Trade and Investment

A current account deficit occurs when a country imports more goods, services,
and income than it exports. A current account surplus occurs when a country exports
more goods, services, and income than it imports. Table A.1 shows that in 2008 the
United States ran a current account deficit of $706 billion. This is often a headline-
grabbing figure and is widely reported in the news media. In recent years the U.S.
current account deficit has been getting steadily larger, primarily because America
imports far more physical goods than it exports (you will notice that America actually
runs a surplus on trade in services and is close to balance on income payments).
The 2006 current account deficit of $803 billion was the largest on record and was
equivalent to about 6.5 percent of the country’s GDP. The deficit shrank a little in
2007 and 2008, and provisional estimates suggested it would fall to about $450 billion
in 2009. Many people find these figures disturbing, the common assumption being
that high imports of goods displaces domestic production, causes unemployment, and
reduces the growth of the U.S. economy. For example, The New York Times responded
to the record current account deficit in 2006 by stating:

A growing trade deficit acts as a drag on overall economic growth. Economists
said that they expect that, in light of the new numbers, the government will have
to revise its estimate of the nation’s fourth quarter gross domestic product to
show slightly slower expansion. 37

CURRENT ACCOUNT $ Millions

Exports of Goods, Services, and Income Receipts $ 2,591,233

Goods 1,276,994

Services 549,602

Income Receipts 764,637

Imports of Goods, Services, and Income Payments 23,168,938

Goods 22,117,245

Services 2405,287

Income Payments 2646,406

Unilateral current transfers (net) 2128,363

Current Account Balance 2706,068

CAPITAL ACCOUNT

Capital Account Transactions (net) 953

FINANCIAL ACCOUNT

U.S.-Owned Assets Abroad, net 2106

U.S. Official Reserve Assets 24,848

U.S. Government Assets 2529,615

U.S. Private Assets 534,357

Foreign-Owned Assets in the United States 534,071

Foreign Official Assets in the United States 487,021

Other Foreign Assets in the United States 47,050

Statistical Discrepancy 200,055

Current Account
Deficit

Occurs when a country
imports more good,

services, and income
than it exports.

Current Account
Surplus

Occurs when a country
exports more goods,

services, and income
than it imports.

table A.1

U.S. Balance of
Payments Accounts,

2008 ($ millions)

Source: Bureau of Economic

Analysis

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Chapter Five International Trade Theory 199

However, the issue is somewhat more complex than implied by statements like this.
Fully understanding the implications of a large and persistent deficit requires that we
look at the rest of the balance-of-payments accounts.
The capital account records onetime changes in the stock of assets. As noted
above, until recently this item was included in the current account. The capital ac-
count includes capital transfers, such as debt forgiveness and migrants’ transfers (the
goods and financial assets that accompany migrants as they enter or leave the country).
In the big scheme of things, this is a relatively small figure amounting to $953 million
in 2008.
The financial account (formally the capital account) records transactions that
involve the purchase or sale of assets. Thus, when a German firm purchases stock in
a U.S. company, or buys a U.S. bond, the transaction enters the U.S. balance of pay-
ments as a credit on the capital account. This is because capital is flowing into the
country. When capital flows out of the United States, it enters the capital account as
a debit.
The financial account is comprised of a number of elements. The net change in
U.S.-owned assets abroad includes the change in assets owned by the U.S. government
(U.S. official reserve assets and U.S. government assets) and the change in assets
owned by private individuals and corporations. As can be seen from Table A.1, in 2008
there was a –$106 million reduction in U.S. assets owned abroad, primarily due to a
$529 billion fall in the amount of foreign assets owned by the U.S. government. In
other words, the government was selling foreign assets, such as foreign bonds and cur-
rencies, during 2008. On the other hand, there was a $534 billion increase in the
amount of foreign assets owned by private entities, indicating that U.S.-owned enter-
prises and private individuals were net buyers of foreign assets in 2008, including for-
eign stocks, bonds, and real estate.
Also included in the financial account are foreign-owned assets in the United States.
These are divided into assets owned by foreign governments (foreign official assets)
and assets owed by other foreign entities such as corporations and individuals (other
foreign assets in the United States). As can be seen, in 2008 foreigners increased their
holdings of U.S. assets, including treasury bills, corporate stocks and bonds, and direct
investments in the United States, by $534 billion. Some $487 billion of this was due to
an increase in the holding of U.S. assets by foreign governments, with the remainder
being due to investments by private corporations and individuals in U.S. assets.
It is important at this point to understand that a basic principle of balance-of-
payments accounting is double-entry bookkeeping. Every international transaction
automatically enters the balance of payments twice—once as a credit and once as a debit.
Imagine that you purchase a car produced in Japan by Toyota for $20,000. Since your
purchase represents a payment to another country for goods, it will enter the balance
of payments as a debit on the current account. Toyota now has the $20,000 and must
do something with it. If Toyota deposits the money at a U.S. bank, Toyota has pur-
chased a U.S. asset—a bank deposit worth $20,000—and the transaction will show up
as a $20,000 credit on the financial account. Or Toyota might deposit the cash in a
Japanese bank in return for Japanese yen. Now the Japanese bank must decide what to
do with the $20,000. Any action that it takes will ultimately result in a credit for the U.S.
balance of payments. For example, if the bank lends the $20,000 to a Japanese firm
that uses it to import personal computers from the United States, then the $20,000
must be credited to the U.S. balance-of-payments current account. Or the Japanese
bank might use the $20,000 to purchase U.S. government bonds, in which case it will
show up as a credit on the U.S. balance-of-payments financial account.
Thus, any international transaction automatically gives rise to two offsetting entries
in the balance of payments. Because of this , the sum of the current account balance, the

Capital Account
Records onetime
changes in the stock
of assets.

Financial Account
Records transactions
that involve the purchase
or sale of assets.

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200 Part Three Cross-Border Trade and Investment

capital account, and the financial account balance should always add up to zero . In practice,
this does not always occur due to the existence of “statistical discrepancies,” the source
of which need not concern us here (in 2008 the statistical discrepancy amounted to
$200 billion).

Does the Current Account Deficit Matter?
As discussed above, there is some concern when a country is running a deficit on
the current account of its balance of payments. 38 In recent years a number of rich
countries, including most notably the United States, have run persistent and grow-
ing current account deficits. When a country runs a current account deficit, the
money that flows to other countries can then be used by those countries to pur-
chase assets in the deficit country. Thus, when the United States runs a trade deficit
with China, the Chinese use the money that they receive from U.S. consumers to
purchase U.S. assets such as stocks, bonds, and the like. Put another way, a deficit
on the current account is financed by selling assets to other countries; that is, by a
surplus on the financial account. Thus, the persistent U.S. current account deficit is
being financed by a steady sale of U.S. assets (stocks, bonds, real estate, and whole
corporations) to other countries. In short, countries that run current account defi-
cits become net debtors.
For example, as a result of financing its current account deficit through asset sales,
the United States must deliver a stream of interest payments to foreign bondholders,
rents to foreign landowners, and dividends to foreign stockholders. One might argue
that such payments to foreigners drain resources from a country and limit the funds
available for investment within the country. Since investment within a country is nec-
essary to stimulate economic growth, a persistent current account deficit can choke off
a country’s future economic growth. This is the basis of the argument that persistent
deficits are bad for an economy.
However, things are not this simple. For one thing, in an era of global capital mar-
kets money is efficiently directed toward its highest value uses, and over the past quar-
ter of a century many of the highest value uses of capital have been in the United
States. So even though capital is flowing out of the United States in the form of pay-
ments to foreigners, much of that capital finds its way right back into the country to
fund productive investments in the United States. In short, it is not clear that the cur-
rent account deficit chokes off U.S. economic growth. In fact, notwithstanding the
2008–2009 recession, the U.S. economy has grown at an impressive rate over the past
25 years, despite running a persistent current account deficit, and despite financing
that deficit by selling U.S. assets to foreigners. This is precisely because foreigners
reinvest much of the income earned from U.S. assets, and from exports to the United
States, right back into the United States. This revisionist view, which has gained in
popularity in recent years, suggests that a persistent current account deficit might not
be the drag on economic growth it was once thought to be. 39
Having said this, there is still a nagging fear that at some point the appetite that
foreigners have for U.S. assets might decline. If foreigners suddenly reduce their in-
vestments in the United States, what would happen? In short, instead of reinvesting
the dollars that they earn from exports and investment in the United States back into
the country, they would sell those dollars for another currency, European euros,
Japanese yen, or Chinese yuan, for example, and invest in euro-, yen- and yuan-
denominated assets instead. This would lead to a fall in the value of the dollar on for-
eign exchange markets, and that in turn would increase the price of imports, and lower
the price of U.S. exports making them more competitive, which should reduce the
overall level of the current account deficit. Thus, in the long run the persistent U.S.

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Chapter Five International Trade Theory 201

current account deficit could be corrected via a reduction in the value of the U.S. dollar.
The concern is that such adjustments may not be smooth. Rather than a controlled
decline in the value of the dollar, the dollar might suddenly lose a significant amount
of its value in a very short time, precipitating a “dollar crisis.” 40 Since the U.S. dollar is
the world’s major reserve currency, and is held by many foreign governments and
banks, any dollar crisis could deliver a body blow to the world economy and at the very
least trigger a global economic slowdown. That would not be a good thing.

balance-of-payments accounts, p. 197
current account, p. 197

current account deficit, p. 198
current account surplus, p. 198

capital account, p. 199
financial account, p. 199

Key Terms

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LEA
R

N
IN

G
O

B
J
E

C
T

IV
E

S After you have read this chapter you should be able to:

1 Identify the policy instruments used by governments to influence international trade flows.
2 Understand why governments sometimes intervene in international trade.
3 Summarize and explain the arguments against strategic trade policy.
4 Describe the development of the world trading system and the current trade issues.
5 Explain the implications for managers of developments in the world trading system.

part 3 Cross-Border Trade and Investment

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opening case

O ver the past 25 years two facts have characterized international trade. First, the volume of world trade has grown every single year, creating an increasingly interdependent global economy, and second, barriers to international trade have been progressively
reduced. Between 1990 and 2007, international trade grew by 6 percent per annum compounded,
while import tariffs on goods fell from an average of 26 percent in1986 to 8.8 percent in 2007. In
the wake of the global financial crisis that started in the United States in 2008 and quickly spread
around the world, this has now changed. As global demand slumped and financing for
international trade dried up in the wake of tight credit conditions, so did the volume of
international trade. The volume of world trade fell by 2 percent in 2008, the first decline since
1982, and a further 9 percent in 2009.
This contraction is alarming because, in the past, sharp declines in trade have been fol-
lowed by calls for greater protectionism from foreign competition as governments try to pro-
tect jobs at home in the wake of declining demand. This occurred in the 1930s, when shrinking
trade was followed quickly by increases in trade barriers, mostly in the form of higher tar-
iffs. This actually made the situation far worse and led to the Great Depression.
Much has changed since the 1930s. Treaties now limit the ability of national govern-
ments to raise trade barriers. Most notably, World Trade Organization rules in theory
constrain the ability of countries to implement significant increases in trade barriers.
But WTO rules are not perfect, and evidence shows that countries are raising bar-
riers to international trade. Many developing countries have latitude under WTO
rules to raise some tariffs, and, according to the World Bank, in 2008 and 2009
they were doing just that. For example, Ecuador raised duties on 600 goods,
Russia increased import tariffs on used cars, while India placed them on
some steel imports.

The Global Financial Crisis and Protectionism

The Political Economy of
International Trade

6 c h a p t e r

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204 Part Three Cross-Border Trade and Investment

According to the World Bank, however, two-thirds of the protectionist mea-
sures taken in 2008 and 2009 are various kinds of “nontariff” barriers that are
designed to get around WTO rules. Indonesia, for example, specified that cer-
tain kinds of goods, including clothes, shoes, and toys, can be imported only
through five ports. Since these ports have limited capacity, this constrains the
ability of foreign companies to sell into the Indonesian market. Argentina has
imposed discretionary licensing requirements on a range of goods including
car parts, textiles, and televisions. If you can’t get a license, you can’t sell into
Argentina. China has stopped a wide range of imports of food and drink
products from Europe, citing safety rules and environmental concerns, while
India has banned imports of toys from China for safety reasons.
Developed nations have in general not taken similar actions, but they have
sharply increased subsidies to troubled domestic producers, which gives
them an advantage against unsubsidized international competitors, and
therefore distorts trade. The key example of this in 2008 and 2009 was the
automobile industry. To protect national producers, hold on to jobs, and stave
of bankruptcies, rich countries including the United States, Great Britain,
Canada, France, Germany, Italy, and Sweden gave over $45 billion in
subsidies to car companies between mid-2008 and mid-2009. Such subsidies
could cause production to switch from more-efficient plants to less-efficient
plants that have an advantage due to state support. Although the WTO has
rules against trade-distorting subsidies, its enforcement mechanisms are
weaker than in the case of tariffs, and so far countries that have been increasing
subsidies have not been challenged. •
Source: “The Nuts and Bolts Come Apart,” The Economist, March 28, 2009, pp. 79–81; “Barriers to Entry,” The
Economist, December 20, 2008, p. 121; and “Beyond Doha,” The Economist, October 11, 2008, pp. 30–33.

Introduction
Our review of the classical trade theories of Smith, Ricardo, and Heckscher-Ohlin in
Chapter 5 showed us that in a world without trade barriers, trade patterns are
determined by the relative productivity of different factors of production in different
countries. Countries will specialize in products that they can make most efficiently,
while importing products that they can produce less efficiently. Chapter 5 also laid out
the intellectual case for free trade. Remember, free trade refers to a situation in which
a government does not attempt to restrict what its citizens can buy from or sell to
another country. As we saw in Chapter 5, the theories of Smith, Ricardo, and
Heckscher-Ohlin predict that the consequences of free trade include both static
economic gains (because free trade supports a higher level of domestic consumption
and more efficient utilization of resources) and dynamic economic gains (because free
trade stimulates economic growth and the creation of wealth).

Free Trade
The absence of

government barriers to
the free flow of goods
and services between

countries.

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Chapter Six The Political Economy of International Trade 205

In this chapter, we look at the political reality
of international trade. Although many nations
are nominally committed to free trade, they
tend to intervene in international trade to
protect the interests of politically important
groups or promote the interests of key domestic
producers. The opening case illustrates the
nature of such political realities. In the wake of
the global economic slowdown that followed
the financial crisis of 2008–2009, a wide range of
countries have been increasing tariffs and non-
tariff barriers to international trade in an
attempt to protect domestic producers, and
hold onto jobs. While such actions are under-
standable from a political perspective, interna-
tional trade theory teaches us that they are
self-defeating. Ultimately, protecting inefficient
producers raises the price of goods and services,
and results in lower economic growth.
In this chapter, we explore the political and economic reasons that governments
have for intervening in international trade. When governments intervene, they of-
ten do so by restricting imports of goods and services into their nation, while
adopting policies that promote domestic production and exports. As in 2008 and
2009, normally their motives are to protect domestic producers. In recent years,
social issues have intruded into the decision-making calculus. In the United States,
for example, a movement is growing to ban imports of goods from countries that
do not abide by the same labor, health, and environmental regulations as the United
States.
We start this chapter by describing the range of policy instruments that govern-
ments use to intervene in international trade. This is followed by a detailed review
of the various political and economic motives that governments have for interven-
tion. In the third section of this chapter, we consider how the case for free trade
stands up in view of the various justifications given for government intervention in
international trade. Then we look at the emergence of the modern international
trading system, which is based on the General Agreement on Tariffs and Trade and
its successor, the WTO. The GATT and WTO are the creations of a series of mul-
tinational treaties. The most recent was completed in 1995, involved more than 12

countries, and resulted in the creation of the WTO. The purpose of these treaties
has been to lower barriers to the free flow of goods and services between nations.
Like the GATT before it, the WTO promotes free trade by limiting the ability of
national governments to adopt policies that restrict imports into their nations. In
the final section of this chapter, we discuss the implications of this material for
management practice.

Instruments of Trade Policy
Trade policy uses seven main instruments: tariffs, subsidies, import quotas, voluntary
export restraints, local content requirements, administrative policies, and antidumping
duties. Tariffs are the oldest and simplest instrument of trade policy. As we shall
see later in this chapter, they are also the instrument that the GATT and WTO have

Another Per spect i ve

Rankings of the World Economic Forum (WEF)
The World Economic Forum (WEF) is an independent
economic organization whose mission is to improve the
state of the world. Based in Geneva, Switzerland, it hosts
meetings that serve as a forum for the collaboration of
international leaders. The WEF also conducts global
economic research and annually publishes country competi-
tive rankings. In the latest report (2009–2010), the top coun-
tries in competitiveness were Switzerland, the United States,
and Singapore, followed by Sweden, Denmark, Finland, and
Germany. If you review the report’s complete list of rankings,
you’ll note a strong correlation between a country’s ranking
and its political system. Visit www.weforum.org.

LEARNING OBJECTIVE 1
Identify the policy

instruments used by
governments to influence
international trade flows.

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206 Part Three Cross-Border Trade and Investment

been most successful in limiting. A fall in tariff barriers in recent decades has been
accompanied by a rise in nontariff barriers, such as subsidies, quotas, voluntary export
restraints, and antidumping duties.

TARIFFS A tariff is a tax levied on imports (or exports). Tariffs fall into two
categories. Specific tariffs are levied as a fixed charge for each unit of a good
imported (for example, $3 per barrel of oil). Ad valorem tariffs are levied as a pro-
portion of the value of the imported good. In most cases, tariffs are placed on
imports to protect domestic producers from foreign competition by raising the price
of imported goods. However, tariffs also produce revenue for the government. Until
the income tax was introduced, for example, the U.S. government received most of
its revenues from tariffs.
The important thing to understand about an import tariff is who suffers and who
gains. The government gains, because the tariff increases government revenues.
Domestic producers gain, because the tariff affords them some protection against
foreign competitors by increasing the cost of imported foreign goods. Consumers
lose because they must pay more for certain imports. For example, in 2002 the U.S.
government placed an ad valorem tariff of 8 percent to 30 percent on imports of
foreign steel. The idea was to protect domestic steel producers from cheap imports
of foreign steel. The effect, however, was to raise the price of steel products in the
United States between 30 and 50 percent. A number of U.S. steel consumers, rang-
ing from appliance makers to automobile companies, objected that the steel tariffs
would raise their costs of production and make it more difficult for them to compete
in the global marketplace. Whether the gains to the government and domestic pro-
ducers exceed the loss to consumers depends on various factors such as the amount
of the tariff, the importance of the imported good to domestic consumers, the num-
ber of jobs saved in the protected industry, and so on. In the steel case, many argued
that the losses to steel consumers apparently outweighed the gains to steel produc-
ers. In November 2003, the World Trade Organization declared that the tariffs
represented a violation of the WTO treaty, and the United States removed them in
December of that year.
In general, two conclusions can be derived from economic analysis of the effect
of import tariffs. 1 First, tariffs are pro-producer and anti-consumer. While they
protect producers from foreign competitors, this restriction of supply also raises
domestic prices. For example, a study by Japanese economists calculated that tariffs

on imports of foodstuffs, cosmetics, and chemi-
cals into Japan cost the average Japanese con-
sumer about $890 per year in the form of higher
prices. 2 Almost all studies find that import tariffs
impose significant costs on domestic consumers
in the form of higher prices. 3

Second, import tariffs reduce the overall effi-
ciency of the world economy. They reduce
efficiency because a protective tariff encourages
domestic firms to produce products at home that,
in theory, could be produced more efficiently
abroad. The consequence is an inefficient utiliza-
tion of resources. For example, tariffs on the im-
portation of rice into South Korea have led to an
increase in rice production in that country; how-
ever, rice farming is an unproductive use of land
in South Korea. It would make more sense for the

Tariff
A tax levied on imports.

Another Per spect i ve

U.S. Tariff Rates
Because the United States takes a free trade public posi-
tion, many people assume the U.S. government has few
tariffs. Information about U.S. trade is readily available
online.
For example, you can review the U.S. government’s
current tariffs at the U.S. Office of Tariff Affairs and Trade
Agreements site (www.usitc.gov/tata/index.htm). However,
with many schedules and fine distinctions made within
product groups, this site can be a challenge to browse. For
interesting statistics on imports and exports of the United
States, as well of as other nations, check out the World
Trade Organization Web site at www.wto.org.

Specific Tariff
A tariff levied as a fixed
charge for each unit of

good imported.

Ad Valorem Tariff
A tariff levied as a

proportion of the value of
an imported good.

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Chapter Six The Political Economy of International Trade 207

South Koreans to purchase their rice from lower-cost foreign producers and to uti-
lize the land now employed in rice production in some other way, such as growing
foodstuffs that cannot be produced more efficiently elsewhere or for residential and
industrial purposes.
Sometimes tariffs are levied on exports of a product from a country. Export tariffs
are far less common than import tariffs. In general, export tariffs have two objectives:
first, to raise revenue for the government, and second, to reduce exports from a sector,
often for political reasons. For example, in 2004 China imposed a tariff on textile ex-
ports. The primary objective was to moderate the growth in exports of textiles from
China, thereby alleviating tensions with other trading partners.

SUBSIDIES A subsidy is a government payment to a domestic producer. Subsi-
dies take many forms, including cash grants, low-interest loans, tax breaks, and gov-
ernment equity participation in domestic firms. By lowering production costs,
subsidies help domestic producers in two ways: (1) competing against foreign imports
and (2) gaining export markets. According to the World Trade Organization, in the
mid-2000s countries spent some $300 billion on subsidies, $250 billion of which was
spent by 21 developed nations. 4 As noted in the opening case, between mid-2008 and
mid-2009 some developed nations gave $45 billion in subsidies to their automobile
makers. While the purpose of the subsidies was to help them survive a very difficult
economic climate, one of the consequences was to give subsidized companies an unfair
competitive advantage in the global auto industry.
Agriculture tends to be one of the largest beneficiaries of subsidies in most coun-
tries. In the mid-2000s, the European Union was paying about €44 billion annually
($55 billion) in farm subsidies. Not to be outdone, in May 2002 President George
W. Bush signed into law a bill that contained subsidies of more than $180 billion
for U.S. farmers spread out over 10 years. This was followed in 2007 by a farm bill
that contained $286 billion in subsidies for the next 10 years. The Japanese also
have a long history of supporting inefficient domestic producers with farm subsi-
dies. The accompanying Country Focus looks at subsidies to wheat producers in
Japan.
Nonagricultural subsidies are much lower, but they are still significant. For
example, subsidies historically were given to Boeing and Airbus to help them lower
the cost of developing new commercial jet aircraft. In Boeing’s case, subsides came
in the form of tax credits for R&D spending or Pentagon money that was used to
develop military technology, which then was transferred to civil aviation projects.
In the case of Airbus, subsidies took the form of government loans at below-market
interest rates.
The main gains from subsidies accrue to domestic producers, whose international
competitiveness is increased as a result. Advocates of strategic trade policy (which, as
you will recall from Chapter 5, is an outgrowth of the new trade theory) favor subsi-
dies to help domestic firms achieve a dominant position in those industries in which
economies of scale are important and the world market is not large enough to profit-
ably support more than a few firms (aerospace and semiconductors are two such in-
dustries). According to this argument, subsidies can help a firm achieve a first-mover
advantage in an emerging industry (just as U.S. government subsidies, in the form of
substantial R&D grants, allegedly helped Boeing). If this is achieved, further gains to
the domestic economy arise from the employment and tax revenues that a major
global company can generate. However, government subsidies must be paid for, typi-
cally by taxing individuals and corporations.
Whether subsidies generate national benefits that exceed their national costs
is debatable. In practice, many subsidies are not that successful at increasing the

Subsidy
Government financial
assistance to a domestic
producer.

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208 Part Three Cross-Border Trade and Investment

international competitiveness of domestic producers. Rather, they tend to protect the
inefficient and promote excess production. One study estimated that if advanced
countries abandoned subsidies to farmers, global trade in agricultural products would
be 50 percent higher and the world as a whole would be better off by $160 billion. 5
Another study estimated that removing all barriers to trade in agriculture (both subsi-
dies and tariffs) would raise world income by $182 billion. 6 This increase in wealth
arises from the more efficient use of agricultural land. For a specific example, see the
Country Focus on wheat subsidies in Japan.

IMPORT QUOTAS AND VOLUNTARY EXPORT RESTRAINTS An
import quota is a direct restriction on the quantity of some good that may be
imported into a country. The restriction is usually enforced by issuing import
licenses to a group of individuals or firms. For example, the United States has a quota
on cheese imports. The only firms allowed to import cheese are certain trading
companies, each of which is allocated the right to import a maximum number of

Subsidized Wheat Production in Japan

Japan is not a particularly good environment for growing
wheat. Wheat produced on large fields in the dry climates
of North America, Australia, and Argentina is far cheaper
and of much higher quality than anything produced in
Japan, which imports some 80 percent of its wheat from
foreign producers. Yet tens of thousands of farmers in
Japan still grow wheat, usually on small fields where yields
are low and costs high, and production is rising. They do
this because government subsidies keep inefficient
Japanese wheat producers in business. In the mid-2000s,
Japanese farmers were selling their output at market
prices, which were running at $9 per bushel, but they
received an average of at least $35 per bushel for their
production! The difference—$26 a bushel—was govern-
ment subsidies paid to producers. The estimated costs of
these subsidies were more than $700 million a year.
To finance its production subsidy, Japan operates a tariff
rate quota on wheat imports in which a higher tariff rate is
imposed once wheat imports exceed the quota level. The
in-quota rate tariff is zero, while the over-quota tariff rate
for wheat is $500 a ton. The tariff raises the cost so much
that it deters over-quota imports, essentially restricting
supply and raising the price for wheat inside Japan. The
Japanese Ministry of Agriculture, Forestry and Fisheries
(MAFF) has the sole right to purchase wheat imports within
the quota (and since there are very few over-quota imports,
the MAFF is a monopoly buyer on wheat imports into
Japan). The MAFF buys wheat at world prices then resells
it to millers in Japan at the artificially high prices that arise

due to the restriction on supply engineered by the tariff
rate quota. Estimates suggest that in 2004, the world mar-
ket price for wheat was $5.96 per bushel, but within Japan
the average price for imported wheat was $10.23 a bushel.
The markup of $4.27 a bushel yielded the MAFF in excess of
$450 million in profit. This “profit” was then used to help
cover the $700 million cost of subsidies to inefficient wheat
farmers, with the rest of the funds coming from general
government tax revenues.
Thanks to these policies, the price of wheat in Japan can
be anything from 80 to 120 percent higher than the world
price, and Japanese wheat production, which exceeded
850,000 tons in 2004, is significantly greater than it would
be if a free market were allowed to operate. Indeed, under
free market conditions, there would be virtually no wheat
production in Japan since the costs of production are sim-
ply too high. The beneficiaries of this policy are the thou-
sands of small farmers in Japan who grow wheat. The
losers include Japanese consumers, who must pay more
for products containing wheat and who must finance
wheat subsidies through taxes, and foreign producers,
who are denied access to a chunk of the Japanese market
by the over-quota tariff rate. Why then does the Japanese
government continue to pursue this policy? It continues
because small farmers are an important constituency and
Japanese politicians want their votes.

Sources: J. Dyck and H. Fukuda, “Taxes on Imports Subsidize Wheat
Production in Japan,” Amber Waves, February 2005, p. 2; and H. Fukuda,
J. Dyck, and J. Stout, “Wheat and Barley Policies in Japan,” U.S. Department
of Agriculture research report, WHS-04i-01, November 2004.

3 Country FOCUS

Import Quota
A direct restriction on

the quantity of some
good that may be

imported into a country.

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Chapter Six The Political Economy of International Trade 209

pounds of cheese each year. In some cases, the right to sell is given directly to the
governments of exporting countries. Historically this is the case for sugar and textile
imports in the United States. However, the international agreement governing the
imposition of import quotas on textiles, the Multi-Fiber Agreement, expired in
December 2004.
A common hybrid of a quota and a tariff is known as a tariff rate quota. Under a
tariff rate quota, a lower tariff rate is applied to imports within the quota than those
over the quota. For example, as illustrated in Figure 6.1, an ad valorem tariff rate of 10
percent might be levied on rice imports into South Korea of 1 million tons, after
which an out-of-quota rate of 80 percent might be applied. Thus, South Korea might
import 2 million tons of rice, 1 million at a 10 percent tariff rate and another

1 million

at an 80 percent tariff. Tariff rate quotas are common in agriculture, where their goal
is to limit imports over quota. For an example, see the Country Focus that looks at
how Japan uses the combination of a tariff rate quota and subsidies to protect ineffi-
cient Japanese wheat farmers from foreign competition.
A variant on the import quota is the voluntary export restraint. A voluntary export
restraint (VER) is a quota on trade imposed by the exporting country, typically at the
request of the importing country’s government. One of the most famous historical
examples is the limitation on auto exports to the United States enforced by Japanese
automobile producers in 1981. A response to direct pressure from the U.S. govern-
ment, this VER limited Japanese imports to no more than 1.68 million vehicles per
year. The agreement was revised in 1984 to allow 1.85 million Japanese vehicles per
year. The agreement was allowed to lapse in 1985, but the Japanese government indi-
cated its intentions at that time to continue to restrict exports to the United States to
1.85 million vehicles per year. 7 Foreign producers agree to VERs because they fear
more damaging punitive tariffs or import quotas might follow if they do not. Agreeing
to a VER is seen as a way to make the best of a bad situation by appeasing protection-
ist pressures in a country.
As with tariffs and subsidies, both import quotas and VERs benefit domestic pro-
ducers by limiting import competition. As with all restrictions on trade, quotas do not

0 80 9010 20 30 40 50 60 7

Quota limit

2 million

1 million

Tariff rate (%)

To
ns

o
f r

ic
e

im
po

rte
d

Out of quota In quota

6.1 figure

Hypothetical Tariff Rate
Quota

Voluntary Export
Restraint (VER)
A quota on trade imposed
by the exporting country,
typically at the request of
the importing country’s
government.

Tariff Rate Quota
The process of applying
a lower tariff rate
to imports within the
quota than those over
the

quota.

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210 Part Three Cross-Border Trade and Investment

benefit consumers. An import quota or VER always raises the domestic price of an
imported good. When imports are limited to a low percentage of the market by a
quota or VER, the price is bid up for that limited foreign supply. The automobile
industry VER mentioned above increased the price of the limited supply of Japanese
imports. According to a study by the U.S. Federal Trade Commission, the automobile
VER cost U.S. consumers about $1 billion per year between 1981 and 1985. That
$1 billion per year went to Japanese producers in the form of higher prices. 8 The extra
profit that producers make when supply is artificially limited by an import quota is
referred to as a quota rent.
If a domestic industry lacks the capacity to meet demand, an import quota can raise
prices for both the domestically produced and the imported good. This happened in
the U.S. sugar industry, in which a tariff rate quota system has long limited the amount
foreign producers can sell in the U.S. market. According to one study, import quotas
have caused the price of sugar in the United States to be as much as 40 percent greater
than the world price. 9 These higher prices have translated into greater profits for U.S.
sugar producers, which have lobbied politicians to keep the lucrative agreement. They
argue U.S. jobs in the sugar industry will be lost to foreign producers if the quota sys-
tem is scrapped.

LOCAL CONTENT REQUIREMENTS A local content requirement is a
requirement that some specific fraction of a good be produced domestically. The re-
quirement can be expressed either in physical terms (e.g., 75 percent of component
parts for this product must be produced locally) or in value terms (e.g., 75 percent of
the value of this product must be produced locally). Local content regulations have
been widely used by developing countries to shift their manufacturing base from the
simple assembly of products whose parts are manufactured elsewhere into the local
manufacture of component parts. They have also been used in developed countries to
try to protect local jobs and industry from foreign competition. For example, a little-
known law in the United States, the Buy America Act, specifies that government agen-
cies must give preference to American products when putting contracts for equipment
out to bid unless the foreign products have a significant price advantage. The law
specifies a product as “American” if 51 percent of the materials by value are produced
domestically. This amounts to a local content requirement. If a foreign company, or an
American one for that matter, wishes to win a contract from a U.S. government agency
to provide some equipment, it must ensure that at least 51 percent of the product by
value is manufactured in the United States.
Local content regulations provide protection for a domestic producer of parts in
the same way an import quota does: by limiting foreign competition. The aggregate
economic effects are also the same; domestic producers benefit, but the restrictions on
imports raise the prices of imported components. In turn, higher prices for imported
components are passed on to consumers of the final product in the form of higher
final prices. So as with all trade policies, local content regulations tend to benefit pro-
ducers and not consumers.

ADMINISTRATIVE POLICIES In addition to the formal instruments of
trade policy, governments of all types sometimes use informal or administrative pol-
icies to restrict imports and boost exports. Administrative trade policies are bu-
reaucratic rules designed to make it difficult for imports to enter a country. It has
been argued that the Japanese are the masters of this trade barrier. In recent decades,
Japan’s formal tariff and nontariff barriers have been among the lowest in the world.

Local Content
Requirement

A requirement that some
specific fraction of a

good be produced
domestically.

Administrative
Trade Policies
Bureaucratic rules

designed to make it
difficult for imports to

enter a country.

Quota Rent
The extra profit

producers make when
supply is artificially
limited by an import

quota.

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Chapter Six The Political Economy of International Trade 211

Dumping
selling goods in a foreign
market at below their
costs of production or
below their “fair” market
value.

Antidumping
Policies
Policies designed to
punish foreign firms that
engage in dumping and
thus protect domestic
producers from unfair
foreign competition.

Countervailing
Duties
Antidumping duties.

However, critics charge that the country’s informal administrative barriers to im-
ports more than compensate for this. For example, at one point the Netherlands
exported tulip bulbs to almost every country in the world except Japan. In Japan,
customs inspectors insisted on checking every tulip bulb by cutting it vertically
down the middle, and even Japanese ingenuity could not put them back together.
Federal Express also initially had a tough time expanding its global express shipping
services into Japan because Japanese customs inspectors insist on opening a large
proportion of express packages to check for pornography, a process that delayed an
“express” package for days. Japan is not the only country that engages in such poli-
cies. France once required that all imported videotape recorders arrive through a
small customs entry point that was both remote and poorly staffed. The resulting
delays kept Japanese VCRs out of the French market until a VER agreement was
negotiated. 10 As with all instruments of trade policy, administrative instruments ben-
efit producers and hurt consumers, who are denied access to possibly superior for-
eign products.

ANTIDUMPING POLICIES In the context of international trade, dumping is
variously defined as selling goods in a foreign market at below their costs of production
or as selling goods in a foreign market at below their “fair” market value. There is a dif-
ference between these two definitions; the fair market value of a good is normally
judged to be greater than the costs of producing that good because the former includes
a “fair” profit margin. Dumping is viewed as a method by which firms unload excess
production in foreign markets. Some dumping may be the result of predatory behavior,
with producers using substantial profits from their home markets to subsidize prices in
a foreign market with a view to driving indigenous competitors out of that market.
Once this has been achieved, so the argument goes, the predatory firm can raise prices
and earn substantial profits.
An alleged example of dumping occurred in 1997, when two South Korean manu-
facturers of semiconductors, LG Semicon and Hyundai Electronics, were accused of
selling dynamic random access memory chips (DRAMs) in the U.S. market at below
their costs of production. This action occurred in the middle of a worldwide glut of
chip-making capacity. It was alleged that the firms were trying to unload their excess
production in the United States.
Antidumping policies are designed to punish foreign firms that engage in dump-
ing. The ultimate objective is to protect domestic producers from unfair foreign
competition. Although antidumping policies vary somewhat from country to country,
the majority are similar to those used in the United States. If a domestic producer
believes that a foreign firm is dumping production in the U.S. market, it can file a
petition with two government agencies, the Commerce Department and the Interna-
tional Trade Commission. In the Korean DRAM case, Micron Technology, a U.S.
manufacturer of DRAMs, filed the petition. The government agencies then investi-
gate the complaint. If a complaint has merit, the Commerce Department may impose
an antidumping duty on the offending foreign imports (antidumping duties are often
called countervailing duties). These duties, which represent a special tariff, can be
fairly substantial and stay in place for up to five years. For example, after reviewing
Micron’s complaint, the Commerce Department imposed 9 percent and 4 percent
countervailing duties on LG Semicon and Hyundai DRAM chips, respectively. The
accompanying Management Focus discusses another example of how a firm, U.S.
Magnesium, used antidumping legislation to gain protection from unfair foreign
competitors.

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212 Part Three Cross-Border Trade and Investment

The Case for Government Intervention
Now that we have reviewed the various instruments of trade policy that governments
can use, it is time to look at the case for government intervention in international trade.
Arguments for government intervention take two paths: political and economic. Politi-
cal arguments for intervention are concerned with protecting the interests of certain
groups within a nation (normally producers), often at the expense of other groups (nor-
mally consumers), or with achieving some political objective that lies outside the sphere
of economic relationships, such as protecting the environment or human rights. Eco-
nomic arguments for intervention are typically concerned with boosting the overall
wealth of a nation (to the benefit of all, both producers and consumers).

LEARNING OBJECTIVE 2
Understand why
governments sometimes
intervene in international
trade.

Management FOCUS

U.S. Magnesium Seeks Protection

In February 2004, U.S. Magnesium, the sole surviving U.S.
producer of magnesium, a metal that is primarily used in
the manufacture of certain automobile parts and aluminum
cans, filed a petition with the U.S. International Trade
Commission (ITC) contending that a surge in imports had
caused material damage to the U.S. industry’s employment,
sales, market share, and profitability. According to U.S.
Magnesium, Russian and Chinese producers had been
selling the metal at prices significantly below market value.
During 2002 and 2003, imports of magnesium into the United
States rose 70 percent, while prices fell by 40 percent and
the market share accounted for by imports jumped to 50
percent from 25 percent.
“The United States used to be the largest producer of
magnesium in the world,” a U.S. Magnesium spokesman
said at the time of the filing. “What’s really sad is that you
can be state of the art and have modern technology, and if
the Chinese, who pay people less than 90 cents an hour,
want to run you out of business, they can do it. And that’s
why we are seeking relief.”
During a yearlong investigation, the ITC solicited input
from various sides in the dispute. Foreign producers and
consumers of magnesium in the United States argued that
falling prices for magnesium during 2002 and 2003 simply
reflected an imbalance between supply and demand due
to additional capacity coming on stream not from Russia or
China but from a new Canadian plant that opened in 2001
and from a planned Australian plant. The Canadian plant
shut down in 2003, the Australian plant never came on
stream, and prices for magnesium rose again in 2004.
Magnesium consumers in the United States also argued
to the ITC that imposing antidumping duties on foreign
imports of magnesium would raise prices in the United
States significantly above world levels. A spokesman for
Alcoa, which mixes magnesium with aluminum to make

alloys for cans, predicted that if antidumping duties were
imposed, high magnesium prices in the United States would
force Alcoa to move some production out of the United
States. Alcoa also noted that in 2003, U.S. Magnesium was
unable to supply all of Alcoa’s needs, forcing the company
to turn to imports. Consumers of magnesium in the automo-
bile industry asserted that high prices in the United States
would drive engineers to design magnesium out of automo-
biles, or force manufacturing elsewhere, which would ulti-
mately hurt everyone.
The six members of the ITC were not convinced by these
arguments. In March 2005, the ITC ruled that both China and
Russia had been dumping magnesium in the United States.
The government decided to impose duties ranging from 50
percent to more than 140 percent on imports of magnesium
from China. Russian producers faced duties ranging from 19
percent to 22 percent. The duties were to be levied for five
years, after which the ITC will revisit the situation.
According to U.S. Magnesium, the favorable ruling would
allow the company to reap the benefits of nearly $50 million
in investments made in its manufacturing plant and enable
the company to boost its capacity by 28 percent by the end
of 2005. Commenting on the favorable ruling, a U.S. Magne-
sium spokesman noted, “Once unfair trade is removed
from the marketplace we’ll be able to compete with any-
one.” U.S. Magnesium’s customers and competitors, how-
ever, did not view the situation in the 2002–2003 period as one
of unfair trade. While the imposition of antidumping duties
no doubt will help to protect U.S. Magnesium and the 400
people it employs from foreign competition, magnesium
consumers in the United States are left wondering if they
will be the ultimate losers.

Sources: D. Anderton, “U.S. Magnesium Lands Ruling on Unfair Imports,”
Deseret News, October 1, 2004, p. D10; “U.S. Magnesium and Its Largest
Consumers Debate before U.S. ITC,” Platt’s Metals Week, February 28,
2005, p. 2; and S. Oberbeck, “U.S. Magnesium Plans Big Utah Production
Expansion,” Salt Lake Tribune, March 30, 2005.

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Chapter Six The Political Economy of International Trade 213

POLITICAL ARGUMENTS FOR INTERVENTION Political arguments
for government intervention cover a range of issues, including preserving jobs, pro-
tecting industries deemed important for national security, retaliating against unfair
foreign competition, protecting consumers from “dangerous” products, furthering the
goals of foreign policy, and advancing the human rights of individuals in exporting
countries.

Protecting Jobs and Industries Perhaps the most common political argument
for government intervention is that it is necessary for protecting jobs and industries
from unfair foreign competition. The tariffs placed on imports of foreign steel by
President George W. Bush in 2002 were designed to do this. (Many steel producers
were located in states that Bush needed to win reelection in 2004.) A political motive
also underlay establishment of the Common Agricultural Policy (CAP) by the Euro-
pean Union. The CAP was designed to protect the jobs of Europe’s politically power-
ful farmers by restricting imports and guaranteeing prices. However, the higher
prices that resulted from the CAP have cost Europe’s consumers dearly. This is true
of many attempts to protect jobs and industries through government intervention.
For example, the imposition of steel tariffs in 2002 raised steel prices for American
consumers, such as automobile companies, making them less competitive in the
global marketplace.

National Security Countries sometimes argue that it is necessary to protect cer-
tain industries because they are important for national security. Defense-related indus-
tries often get this kind of attention (e.g., aerospace, advanced electronics,
semiconductors, etc.). Although not as common as it used to be, this argument is still
made. Those in favor of protecting the U.S. semiconductor industry from foreign
competition, for example, argue that semiconductors are now such important compo-
nents of defense products that it would be dangerous to rely primarily on foreign
producers for them. In 1986, this argument helped persuade the federal government
to support Sematech, a consortium of 14 U.S. semiconductor companies that ac-
counted for 90 percent of the U.S. industry’s revenues. Sematech’s mission was to
conduct joint research into manufacturing techniques that can be parceled out to
members. The government saw the venture as so critical that Sematech was specially
protected from antitrust laws. Initially, the U.S. government provided Sematech with
$100 million per year in subsidies. By the mid-1990s, however, the U.S. semiconduc-
tor industry had regained its leading market position, largely through the personal
computer boom and demand for microprocessor chips made by Intel. In 1994, the
consortium’s board voted to seek an end to federal funding, and since 1996 the consor-
tium has been funded entirely by private money. 11

Retaliation Some argue that governments should use the threat to intervene in
trade policy as a bargaining tool to help open foreign markets and force trading part-
ners to “play by the rules of the game.” The U.S. government has used the threat of
punitive trade sanctions to try to get the Chinese government to enforce its intellec-
tual property laws. Lax enforcement of these laws had given rise to massive copyright
infringements in China that had been costing U.S. companies such as Microsoft hun-
dreds of millions of dollars per year in lost sales revenues. After the United States
threatened to impose 100 percent tariffs on a range of Chinese imports, and after
harsh words between officials from the two countries, the Chinese agreed to tighter
enforcement of intellectual property regulations. 12
If it works, such a politically motivated rationale for government intervention
may liberalize trade and bring with it resulting economic gains. It is a risky strategy,

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214 Part Three Cross-Border Trade and Investment

however. A country that is being pressured may not back down and instead may re-
spond to the imposition of punitive tariffs by raising trade barriers of its own. This
is exactly what the Chinese government threatened to do when pressured by the
United States, although it ultimately did back down. If a government does not back
down, however, the results could be higher trade barriers all around and an eco-
nomic loss to all involved.

Protecting Consumers Many governments have long had regulations to protect
consumers from unsafe products. The indirect effect of such regulations often is to
limit or ban the importation of such products. For example, in 2003 several countries,
including Japan and South Korea, decided to ban imports of American beef after a
single case of mad cow disease was found in Washington State. The ban was motivated
to protect consumers from what was seen to be an unsafe product. Together, Japan and
South Korea accounted for about $2 billion of U.S. beef sales, so the ban had a sig-
nificant impact on U.S. beef producers. After two years, both countries lifted the ban,
although they placed stringent requirements on U.S. beef imports to reduce the risk of
importing beef that might be tainted by mad cow disease (for example, Japan required
that all beef must come from cattle under 21 months of age). 13
The accompanying Country Focus describes how the European Union banned
the sale and importation of hormone-treated beef. The ban was motivated by a de-
sire to protect European consumers from the possible health consequences of eating
meat from animals treated with growth hormones. The conflict over the importa-
tion of hormone-treated beef into the EU may prove to be a taste of things to come.
In addition to the use of hormones to promote animal growth and meat production,
biotechnology has made it possible to genetically alter many crops so that they resist
common herbicides, produce proteins that are natural insecticides, grow dramati-
cally improved yields, or withstand inclement weather conditions. A new breed of

A genetically engineered cotton seed that protects against three common insects has been met with resistance in Europe
due to a fear that these genetically altered seeds could potentially be harmful to humans.

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Chapter Six The Political Economy of International Trade 215

genetically modified tomatoes has an antifreeze gene inserted into its genome and
can thus be grown in colder climates than hitherto possible. Another example is a
genetically engineered cotton seed produced by Monsanto. The seed has been engi-
neered to express a protein that protects against three common insect pests: the
cotton bollworm, tobacco budworm, and pink bollworm. Use of this seed reduces or
eliminates the need for traditional pesticide applications for these pests.
As enticing as such innovations sound, they have met with intense resistance from
consumer groups, particularly in Europe. The fear is that the widespread use of
genetically altered seed corn could have unanticipated and harmful effects on human

Trade in Hormone-Treated Beef

In the 1970s, scientists discovered how to synthesize cer-
tain hormones and use them to accelerate the growth rate
of livestock animals, reduce the fat content of meat, and
increase milk production. Bovine somatotropin (BST), a
growth hormone produced by cattle, was first synthesized
by the biotechnology firm Genentech. Injections of BST
could be used to supplement an animal’s own hormone
production and increase its growth rate. These hormones
soon became popular among farmers, who found that they
could cut costs and help satisfy consumer demands for
leaner meat. Although these hormones occurred naturally
in animals, consumer groups in several countries soon
raised concerns about the practice. They argued that the
use of hormone supplements was unnatural and that the
health consequences of consuming hormone-treated meat
were unknown but might include hormonal irregularities
and cancer.
The European Union responded to these concerns in
1989 by banning the use of growth-promoting hormones
in the production of livestock and the importation of
hormone-treated meat. The ban was controversial because
a reasonable consensus existed among scientists that the
hormones posed no health risk. Although the EU banned
hormone-treated meat, many other countries did not,
including big meat-producing countries such as Australia,
Canada, New Zealand, and the United States. The use of
hormones soon became widespread in these countries.
According to trade officials outside the EU, the European
ban constituted an unfair restraint on trade. As a result of
this ban, exports of meat to the EU fell. For example, U.S.
red meat exports to the EU declined from $231 million in
1988 to $98 million in 1994. The complaints of meat export-
ers were bolstered in 1995 when Codex Alimentarius, the
international food standards body of the UN’s Food and Ag-
riculture Organization and the World Health Organization,
approved the use of growth hormones. In making this deci-
sion, Codex reviewed the scientific literature and found no

evidence of a link between the consumption of hormone-
treated meat and human health problems, such as cancer.
Fortified by such decisions, in 1995 the United States
pressed the EU to drop the import ban on hormone-treated
beef. The EU refused, citing “consumer concerns about food
safety.” In response, both Canada and the United States in-
dependently filed formal complaints with the World Trade
Organization. The United States was joined in its complaint
by a number of other countries, including Australia and New
Zealand. The WTO created a trade panel of three indepen-
dent experts. After reviewing evidence and hearing from a
range of experts and representatives of both parties, the
panel in May 1997 ruled that the EU ban on hormone-treated
beef was illegal because it had no scientific justification.
The EU immediately indicated it would appeal the finding to
the WTO court of appeals. The WTO court heard the appeal
in November 1997 and in February 1998 agreed with the find-
ings of the trade panel that the EU had not presented any
scientific evidence to justify the hormone ban.
This ruling left the EU in a difficult position. Legally, the EU
had to lift the ban or face punitive sanctions, but the ban
had wide public support in Europe. The EU feared that lifting
the ban could produce a consumer backlash. Instead the
EU did nothing, so in February 1999 the United States asked
the WTO for permission to impose punitive sanctions on the
EU. The WTO responded by allowing the United States to
impose punitive tariffs valued at $120 million on EU exports
to the United States. The EU decided to accept these tariffs
rather than lift the ban on hormone-treated beef, and as of
2010, the ban and punitive tariffs were still in place.

Sources: C. Southey, “Hormones Fuel a Meaty EU Row,” Financial Times,
September 7, 1995, p. 2; E. L. Andrews, “In Victory for U.S., European Ban on
Treated Beef Is Ruled Illegal,” The New York Times, May 9, 1997, p. A1;
F. Williams and G. de Jonquieres, “WTO’s Beef Rulings Give Europe Food
for Thought,” Financial Times, February 13, 1998, p. 5; R. Baily, “Food and
Trade: EU Fearmongers’ Lethal Harvest,” Los Angeles Times, August 18, 2002,
p. M3; “The US-EU Dispute over Hormone-Treated Beef,” The Kiplinger
Agricultural Letter, January 10, 2003; and Scott Miller, “EU Trade Sanctions
Have Duel Edge,” The Wall Street Journal, February 26, 2004, p. A3.

3 Country FOCUS

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216 Part Three Cross-Border Trade and Investment

health and may result in “genetic pollution.” (An example of genetic pollution would be
when the widespread use of crops that produce natural pesticides stimulates the evolu-
tion of “superbugs” that are resistant to those pesticides.) Such concerns have led Austria
and Luxembourg to outlaw the importation, sale, or use of genetically altered organ-
isms. Sentiment against genetically altered organisms also runs strong in several other
European countries, most notably Germany and Switzerland. It seems likely, therefore,
that the World Trade Organization will be drawn into the conflict between those that
want to expand the global market for genetically altered organisms, such as Monsanto,
and those that want to limit it, such as Austria and Luxembourg. 14

Furthering Foreign Policy Objectives Governments sometimes use trade
policy to support their foreign policy objectives. 15 A government may grant prefer-
ential trade terms to a country with which it wants to build strong relations. Trade
policy has also been used several times to pressure or punish “rogue states” that do
not abide by international law or norms. Iraq labored under extensive trade sanc-
tions after the UN coalition defeated the country in the 1991 Gulf War until the
2003 invasion of Iraq by U.S.-led forces. The theory is that such pressure might
persuade the rogue state to mend its ways, or it might hasten a change of govern-
ment. In the case of Iraq, the sanctions were seen as a way of forcing that country
to comply with several UN resolutions. The United States has maintained long-
running trade sanctions against Cuba. Their principal function is to impoverish Cuba
in the hope that the resulting economic hardship will lead to the downfall of Cuba’s
Communist government and its replacement with a more democratically inclined
(and pro-U.S.) regime. The United States also has had trade sanctions in place
against Libya and Iran, both of which it accuses of supporting terrorist action against
U.S. interests and building weapons of mass destruction. In late 2003, the sanctions
against Libya seemed to yield some returns when that country announced it would
terminate a program to build nuclear weapons, and the U.S. government responded
by relaxing those sanctions.
Other countries can undermine unilateral trade sanctions. The U.S. sanctions
against Cuba, for example, have not stopped other Western countries from trading
with Cuba. The U.S. sanctions have done little more than help create a vacuum into
which other trading nations, such as Canada and Germany, have stepped. In an attempt
to halt this and further tighten the screws on Cuba, in 1996 the U.S. Congress passed
the Helms-Burton Act. This act allows Americans to sue foreign firms that use prop-
erty in Cuba confiscated from them after the 1959 revolution. Later in 1996, Congress
passed a similar law, the D’Amato Act, aimed at Libya and Iran.
The passage of Helms-Burton elicited protests from America’s trading partners,
including the European Union, Canada, and Mexico, all of which claim the law vio-
lates their sovereignty and is illegal under World Trade Organization rules. For
example, Canadian companies that have been doing business in Cuba for years see no
reason they should suddenly be sued in U.S. courts when Canada does not restrict
trade with Cuba. They are not violating Canadian law, and they are not U.S. compa-
nies, so why should they be subject to U.S. law? Despite such protests, the law is still
on the books in the United States, although the U.S. government has not enforced this
act—probably because it is unenforceable.

Protecting Human Rights Protecting and promoting human rights in other
countries is an important element of foreign policy for many democracies. Govern-
ments sometimes use trade policy to try to improve the human rights policies of trad-
ing partners. For years, the most obvious example of this was the annual debate in the
United States over whether to grant most favored nation (MFN) status to China.

Helms-Burton Act
Act passed in 1996 that

allowed Americans to
sue foreign firms that

use Cuban property
confiscated from them

after the 1959 revolution.

D’Amato Act
Act passed in 1996,

similar to the Helms-
Burton Act, aimed at

Libya and Iran.

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Chapter Six The Political Economy of International Trade 217

MFN status allows countries to export goods to the
United States under favorable terms. Under MFN
rules, the average tariff on Chinese goods imported
into the United States was 8 percent. If China’s MFN
status were rescinded, tariffs could have risen to
about 40 percent. Trading partners who are signato-
ries of the World Trade Organization, as most are,
automatically receive MFN status. However, China
did not join the WTO until 2001, so historically the
decision of whether to grant MFN status to China
was a real one. The decision was made more difficult
by the perception that China had a poor human
rights record. As indications of the country’s disre-
gard for human rights, critics of China often point to
the 1989 Tiananmen Square massacre, China’s con-
tinuing subjugation of Tibet (which China occupied
in the 1950s), and the squashing of political dissent in China. 16 These critics argue that
it was wrong for the United States to grant MFN status to China, and that instead, the
United States should withhold MFN status until China showed measurable improve-
ment in its human rights record. The critics argue that trade policy should be used as
a political weapon to force China to change its internal policies toward human rights.
Others contend that limiting trade with such countries would make matters worse,
not better. They argue that the best way to change the internal human rights stance of a
country is to engage it through international trade. At its core, the argument is simple:
Growing bilateral trade raises the income levels of both countries, and as a state be-
comes richer, its people begin to demand, and generally receive, better treatment with
regard to their human rights. This is a variant of the argument in Chapter 2 that eco-
nomic progress begets political progress (if political progress is measured by the adop-
tion of a democratic government that respects human rights). This argument ultimately
won the day in 1999 when the Clinton administration blessed China’s application to join
the WTO and announced that trade and human rights issues should be decoupled.

Protecting the Environment Protecting the environment has become an im-
portant policy objective of many nations. Increasingly, environmental interest groups
such as Friends of the Earth and the Sierra Club have been pressuring governments to
regulate international trade in a way the protects the environment. The growing con-
cern over global warming has added an important dimension to this debate.
One argument frequently made by environmental organizations is that there is a
strong relationship between income levels and environmental pollution and degra-
dation (i.e., industrial development leads to more pollution). Thus, to the extent
that international trade leads to higher income levels, it can also be expected to lead
to a decline in environmental quality. Organizations such as the Sierra Club argue
that as a consequence, strong environmental safeguards need to be part of any trade
agreements, and governments should be allowed to restrict trade if doing so bene-
fits the environment.
As noted in Chapter 1, the empirical evidence suggests the relationship between
income levels and pollution is not a linear one—rather it is an inverted U-shaped rela-
tionship (see Figure 1.5). 17 To begin with, as countries start to climb the ladder of
economic progress, pollution levels do increase, but past some threshold, they start to
decline. The reason being that as societies get richer, citizens lobby for environmental
protections, and governments tend to respond. We can see this process starting to
unfold today in China. China has had an awful reputation for pollution, but in the last

Beijing’s Tiananmen Square, a tangible reminder of China’s history of
human rights abuses.

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218 Part Three Cross-Border Trade and Investment

few years the Chinese government has been working hard to improve the air quality in
its major cities (although the country still has a considerable way to go). In developed
nations such as the United States and United Kingdom, the air is much cleaner that it
was half a century ago. This data suggests that international trade, and the growth that
results from it, may not be damaging to the environment.
There is a very important exception to these trends, however, and that is emissions
of carbon dioxide. Carbon dioxide emissions do rise with income levels. Thus, the
country with the highest income per capita, the United States, also produces the great-
est carbon dioxide emissions per capita. The reason is that carbon dioxide emissions
are a by-product of energy use (i.e., oil, gas, or coal burning). Richer societies are more
energy intensive, and to the extent that they use hydrocarbons to produce that energy,
this leads to higher carbon dioxide emissions.
Carbon dioxide is the greenhouse gas at the center of concerns over global warm-
ing. These concerns can be stated simply. 18 First, the burning of fossil fuels to produce
energy also releases carbon dioxide into the atmosphere (and atmospheric carbon
dioxide concentrations have steadily increased since preindustrial times). Second, car-
bon dioxide absorbs heat radiated from the earth, warming the atmosphere. Third, as
a consequence, average global temperatures will increase. Indeed, estimates suggest
that average global temperatures increased by 0.7 degree centigrade during the past
century, and they are forecasted to rise by between 1.1 and 6.4 degrees centigrade this
century. 19 Fourth, as global temperatures increase, there will be environmental dislo-
cation, ice caps will melt and sea levels will rise, flooding low-lying costal areas;
weather patterns will change; the frequency of violent storms will increase; tropical
diseases (such as malaria) will move northward; species will go extinct; and so on.
Of course, the global climate varies naturally due too, for example, changes in solar
radiation connected with the well-known sun spot cycle, volcanic activity (which can
inject large amounts of sulfur dioxide particles into the atmosphere, temporarily cool-
ing it), changes in the circulation of ocean currents, and long-term changes in the
orbit of the earth and the tilt of its axis. Human-induced global warming is overlaid on
these natural variations. Thus, a natural cooling trend might be moderated by greater
atmospheric carbon dioxide concentrations, and a natural warming trend exacerbated
by them.
Although there is debate over the precise relationship between carbon dioxide con-
centrations and the extent of future global warming, the vast majority of climate scien-
tists have concluded that unless we take rapid action, we face a rate of warming that in
unprecedented during the history of our civilization and may cause major environ-
mental dislocation. 20 Given this, they advocate restricting greenhouse gas emissions,
particularly carbon dioxide. The first international agreement to limit global warming,
the Kyoto Protocol, was signed in 1997, although its impact was reduced by the failure
of two of the world’s largest producers of carbon dioxide, the United States and China,
to sign. A second international agreement was reached in Copenhagen in 2009, this
time with the participation of the United States and China.
What does this have to do with international trade? So far, there has been little
direct connection between the global warming debate and international trade. How-
ever, looking forward, adherence to targets regarding carbon emissions might start to
factor into trade agreements. Specifically, if countries do not meet their targets for
reducing carbon emissions specified in international treaties, they may find them-
selves the targets of retaliatory action. The EU, for example, might respond to the
failure of the United States to meet its treaty commitments by placing a carbon tariff
on the import of certain goods from the United States. Ten years ago this was a re-
mote possibility. Ten years from now it may be a significant factor in the international
trade environment.

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Chapter Six The Political Economy of International Trade 219

A second argument made with regard to environmental regulations is that, to save
money, corporations will move production to countries where environmental regu-
lations are lax. Thus, for example, if tight environmental standards in the United
States raise costs, a manufacturing firm might move production to a pollution haven
such as Mexico where environmental standards are weaker. To protect against this
possibility, environmental organizations argue that governments should place tariffs
or other limitations on goods imported from countries where environmental regula-
tions are lax.
Economists have studied this issue but have found little evidence that firms do
move production in response to changes in pollution regulations. 21 Their findings
suggest that pollution abatement costs are a relatively small component of the cost
structure of most enterprises, and that other factors, such as labor productivity, access
to technological know-how, and transportation costs are far more important in deter-
mining location decisions. It is also worth noting that migrating to a pollution haven
would violate the ethical principles of many (but not all) organizations (see Chapter 4
for details).
In sum, although environmental concerns have not figured significantly in trade
treaties to date, there is a good chance that they will do so in the future, particularly
with regard to the emission of carbon dioxide and other greenhouse gases.

ECONOMIC ARGUMENTS FOR INTERVENTION With the develop-
ment of the new trade theory and strategic trade policy (see Chapter 5), the eco-
nomic arguments for government intervention have undergone a renaissance in
recent years. Until the early 1980s, most economists saw little benefit in government
intervention and strongly advocated a free trade policy. This position has changed at
the margins with the development of strategic trade policy, although as we will see
in the next section, there are still strong economic arguments for sticking to a free
trade stance.

The Infant Industry Argument The infant industry argument is by far the
oldest economic argument for government intervention. Alexander Hamilton pro-
posed it in 1792. According to this argument, many developing countries have a
potential comparative advantage in manufacturing, but new manufacturing industries
cannot initially compete with established industries in developed countries. To allow
manufacturing to get a toehold, the argument is that governments should temporarily
support new industries (with tariffs, import quotas, and subsidies) until they have
grown strong enough to meet international competition.
This argument has had substantial appeal for the governments of developing
nations during the past 50 years, and the GATT has recognized the infant industry
argument as a legitimate reason for protectionism. Nevertheless, many economists
remain critical of this argument for two main reasons. First, protection of manufactur-
ing from foreign competition does no good unless the protection helps make the
industry efficient. In case after case, however, protection seems to have done little
more than foster the development of inefficient industries that have little hope of ever
competing in the world market. Brazil, for example, built the world’s tenth-largest
auto industry behind tariff barriers and quotas. Once those barriers were removed in
the late 1980s, however, foreign imports soared, and the industry was forced to face up
to the fact that after 30 years of protection, the Brazilian industry was one of the
world’s most inefficient. 22
Second, the infant industry argument relies on an assumption that firms are unable
to make efficient long-term investments by borrowing money from the domestic
or international capital market. Consequently, governments have been required to

Infant Industry
Argument
New industries in
developing countries
must be temporarily
protected from
international competition
to help them reach a
position where they can
compete on world
markets with the firms of
developed nations.

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220 Part Three Cross-Border Trade and Investment

subsidize long-term investments. Given the development of global capital markets
over the past 20 years, this assumption no longer looks as valid as it once did. Today,
if a developing country has a potential comparative advantage in a manufacturing
industry, firms in that country should be able to borrow money from the capital mar-
kets to finance the required investments. Given financial support, firms based in
countries with a potential comparative advantage have an incentive to endure the
necessary initial losses in order to make long-run gains without requiring govern-
ment protection. Many Taiwanese and South Korean firms did this in industries such
as textiles, semiconductors, machine tools, steel, and shipping. Thus, given efficient
global capital markets, the only industries that would require government protection
would be those that are not worthwhile.

Strategic Trade Policy Some new trade theorists have proposed the strategic
trade policy argument. 23 We reviewed the basic argument in Chapter 5 when we con-
sidered the new trade theory. The new trade theory argues that in industries in which
the existence of substantial economies of scale implies that the world market will prof-
itably support only a few firms, countries may predominate in the export of certain
products simply because they had firms that were able to capture first-mover advan-
tages. The long-term dominance of Boeing in the commercial aircraft industry has
been attributed to such factors.
The strategic trade policy argument has two components. First, it is argued that
by appropriate actions, a government can help raise national income if it can some-
how ensure that the firm or firms that gain first-mover advantages in an industry are
domestic rather than foreign enterprises. Thus, according to the strategic trade pol-
icy argument, a government should use subsidies to support promising firms that
are active in newly emerging industries. Advocates of this argument point out that
the substantial R&D grants that the U.S. government gave Boeing in the 1950s
and 1960s probably helped tilt the field of competition in the newly emerging mar-
ket for passenger jets in Boeing’s favor. (Boeing’s first commercial jet airliner, the
707, was derived from a military plane.) Similar arguments have been made with
regard to Japan’s dominance in the production of liquid crystal display screens (used
in laptop computers). Although these screens were invented in the United States,
the Japanese government, in cooperation with major electronics companies, tar-
geted this industry for research support in the late 1970s and early 1980s. The result
was that Japanese firms, not U.S. firms, subsequently captured first-mover advan-
tages in this market.
The second component of the strategic trade policy argument is that it might pay a
government to intervene in an industry by helping domestic firms overcome the bar-
riers to entry created by foreign firms that have already reaped first-mover advantages.
This argument underlies government support of Airbus, Boeing’s major competitor.
Formed in 1966 as a consortium of four companies from Great Britain, France,
Germany, and Spain, Airbus had less than 5 percent of the world commercial aircraft
market when it began production in the mid-1970s. By 2009, it had increased its share
to 45 percent, threatening Boeing’s long-term dominance of the market. How did
Airbus achieve this? According to the U.S. government, the answer is a $15 billion
subsidy from the governments of Great Britain, France, Germany, and Spain. 24 With-
out this subsidy, Airbus would never have been able to break into the world market.
If these arguments are correct, they support a rationale for government interven-
tion in international trade. Governments should target technologies that may be
important in the future and use subsidies to support development work aimed at com-
mercializing those technologies. Furthermore, government should provide export
subsidies until the domestic firms have established first-mover advantages in the world

Strategic Trade
Policy

Government policy aimed
at improving the

competitive position of a
domestic industry or
domestic firm in the

world market.

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Chapter Six The Political Economy of International Trade 221

market. Government support may also be justified if it can help domestic firms over-
come the first-mover advantages enjoyed by foreign competitors and emerge as viable
competitors in the world market (as in the Airbus and semiconductor examples). In
this case, a combination of home-market protection and export-promoting subsidies
may be needed.

The Revised Case for Free Trade
The strategic trade policy arguments of the new trade theorists suggest an economic
justification for government intervention in international trade. This justification chal-
lenges the rationale for unrestricted free trade found in the work of classic trade theorists
such as Adam Smith and David Ricardo. In response to this challenge to economic ortho-
doxy, a number of economists—including some of those responsible for the development
of the new trade theory, such as Paul Krugman—point out that although strategic trade
policy looks appealing in theory, in practice it may be unworkable. This response to the
strategic trade policy argument constitutes the revised case for free trade. 25

RETALIATION AND TRADE WAR Krugman argues that a strategic trade
policy aimed at establishing domestic firms in a dominant position in a global industry
is a beggar-thy-neighbor policy that boosts national income at the expense of other
countries. A country that attempts to use such policies will probably provoke retalia-
tion. In many cases, the resulting trade war between two or more interventionist gov-
ernments will leave all countries involved worse off than if a hands-off approach had
been adopted in the first place. If the U.S. government were to respond to the Airbus
subsidy by increasing its own subsidies to Boeing, for example, the result might be that
the subsidies would cancel each other out. In the process, both European and U.S.
taxpayers would end up supporting an expensive and pointless trade war, and both
Europe and the United States would be worse off.
Krugman may be right about the danger of a strategic trade policy leading to a trade
war. The problem, however, is how to respond when one’s competitors are already being
supported by government subsidies; that is, how should Boeing and the United States
respond to the subsidization of Airbus? According to Krugman, the answer is pro-
bably not to engage in retaliatory action but to help establish rules of the game that
minimize the use of trade-distorting subsidies. This is what the World Trade Organiza-
tion seeks to do.

DOMESTIC POLICIES Governments do not always act in the national interest
when they intervene in the economy; politically important interest groups often influ-
ence them. The European Union’s support for the Common Agricultural Policy
(CAP), which arose because of the political power of French and German farmers, is
an example. The CAP benefited inefficient farmers and the politicians who relied on
the farm vote, but not consumers in the EU, who end up paying more for their food-
stuffs. Thus, a further reason for not embracing strategic trade policy, according to
Krugman, is that such a policy is almost certain to be captured by special-interest
groups within the economy, who will distort it to their own ends. Krugman concludes
that in the United States,

To ask the Commerce Department to ignore special-interest politics while for-
mulating detailed policy for many industries is not realistic: To establish a blan-
ket policy of free trade, with exceptions granted only under extreme pressure,
may not be the optimal policy according to the theory but may be the best policy
that the country is likely to get. 26

LEARNING OBJECTIVE 3
Summarize and explain the

arguments against strategic
trade policy.

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222 Part Three Cross-Border Trade and Investment

Development of the World Trading System
Strong economic arguments support unrestricted free trade. While many govern-
ments have recognized the value of these arguments, they have been unwilling to uni-
laterally lower their trade barriers for fear that other nations might not follow suit.
Consider the problem that two neighboring countries, say, Brazil and Argentina, face
when deciding whether to lower trade barriers between them. In principle, the gov-
ernment of Brazil might favor lowering trade barriers, but it might be unwilling to do
so for fear that Argentina will not do the same. Instead, the government might fear
that the Argentineans will take advantage of Brazil’s low barriers to enter the Brazilian
market, while at the same time continuing to shut Brazilian products out of their mar-
ket through high trade barriers. The Argentinean government might believe that it
faces the same dilemma. The essence of the problem is a lack of trust. Both govern-
ments recognize that their respective nations will benefit from lower trade barriers
between them, but neither government is willing to lower barriers for fear that the
other might not follow. 27
Such a deadlock can be resolved if both countries negotiate a set of rules to govern
cross-border trade and lower trade barriers. But who is to monitor the governments to
make sure they are playing by the trade rules? And who is to impose sanctions on a
government that cheats? Both governments could set up an independent body to act
as a referee. This referee could monitor trade between the countries, make sure that
no side cheats, and impose sanctions on a country if it does cheat in the trade game.
While it might sound unlikely that any government would compromise its national
sovereignty by submitting to such an arrangement, since World War II an international
trading framework has evolved that has exactly these features. For its first 50 years,
this framework was known as the General Agreement on Tariffs and Trade. Since
1995, it has been known as the World Trade Organization. Here we look at the evolu-
tion and workings of the GATT and WTO.

FROM SMITH TO THE GREAT DEPRESSION As noted in Chapter 5,
the theoretical case for free trade dates to the late eighteenth century and the work of
Adam Smith and David Ricardo. Free trade as a government policy was first officially
embraced by Great Britain in 1846, when the British Parliament repealed the Corn
Laws. The Corn Laws placed a high tariff on imports of foreign corn. The objectives
of the Corn Laws tariff were to raise government revenues and to protect British corn
producers. There had been annual motions in Parliament in favor of free trade since
the 1820s when David Ricardo was a member. However, agricultural protection was
withdrawn only as a result of a protracted debate when the effects of a harvest failure
in Great Britain were compounded by the imminent threat of famine in Ireland. Faced
with considerable hardship and suffering among the populace, Parliament narrowly
reversed its long-held position.
During the next 80 years or so, Great Britain, as one of the world’s dominant trad-
ing powers, pushed the case for trade liberalization; but the British government was a
voice in the wilderness. Its major trading partners did not reciprocate the British pol-
icy of unilateral free trade. The only reason Britain kept this policy for so long was
that as the world’s largest exporting nation, it had far more to lose from a trade war
than did any other country.
By the 1930s, the British attempt to stimulate free trade was buried under the eco-
nomic rubble of the Great Depression. The Great Depression had roots in the failure
of the world economy to mount a sustained economic recovery after the end of World
War I in 1918. Things got worse in 1929 with the U.S. stock market collapse and the
subsequent run on the U.S. banking system. Economic problems were compounded

LEARNING OBJECTIVE 4
Describe the development
of the world trading system
and the current trade
issues.

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Chapter Six The Political Economy of International Trade 223

in 1930 when the U.S. Congress passed the Smoot-Hawley tariff. Aimed at avoiding
rising unemployment by protecting domestic industries and diverting consumer de-
mand away from foreign products, the Smoot-Hawley Act erected an enormous wall
of tariff barriers. Almost every industry was rewarded with its “made-to-order” tariff.
A particularly odd aspect of the Smoot-Hawley tariff-raising binge was that the
United States was running a balance-of-payment surplus at the time and it was the
world’s largest creditor nation. The Smoot-Hawley Act had a damaging effect on
employment abroad. Other countries reacted to the U.S. action by raising their own
tariff barriers. U.S. exports tumbled in response, and the world slid further into the
Great Depression. 28

1947–1979: GATT, TRADE LIBERALIZATION, AND ECONOMIC
GROWTH Economic damage caused by the beggar-thy-neighbor trade policies
that the Smoot-Hawley Act ushered in exerted a profound influence on the economic
institutions and ideology of the post–World War II world. The United States emerged
from the war both victorious and economically dominant. After the debacle of the
Great Depression, opinion in the U.S. Congress had swung strongly in favor of free
trade. Under U.S. leadership, the GATT was established in 1947.
The GATT was a multilateral agreement whose objective was to liberalize trade by
eliminating tariffs, subsidies, import quotas, and the like. From its foundation in 1947
until it was superseded by the WTO, the GATT’s membership grew from 19 to more
than 120 nations. The GATT did not attempt to liberalize trade restrictions in one fell
swoop; that would have been impossible. Rather, tariff reduction was spread over eight
rounds. The last, the Uruguay Round, was launched in 1986 and completed in
December 1993. In these rounds, mutual tariff reductions were negotiated among all
members, who then committed themselves not to raise import tariffs above negotiated
rates. GATT regulations were enforced by a mutual monitoring mechanism. If a
country believed that one of its trading partners was violating a GATT regulation, it
could ask the Geneva-based bureaucracy that administered the GATT to investigate.
If GATT investigators found the complaints to be valid, member countries could be
asked to pressure the offending party to change its policies. In general, such pressure
was sufficient to get an offending country to change its policies. If it were not, the
offending country could be expelled from the GATT.
In its early years, the GATT was by most measures very successful. For example,
the average tariff declined by nearly 92 percent in the United States between the
Geneva Round of 1947 and the Tokyo Round of 1973–79. Consistent with the the-
oretical arguments first advanced by Ricardo and reviewed in Chapter 5, the move
toward free trade under the GATT appeared to stimulate economic growth. From
1953 to 1963, world trade grew at an annual rate of 6.1 percent, and world income
grew at an annual rate of 4.3 percent. Performance from 1963 to 1973 was even
better; world trade grew at 8.9 percent annually, and world income grew at 5.1 per-
cent annually. 29

1980–1993: PROTECTIONIST TRENDS During the 1980s and early
1990s, the world trading system erected by the GATT came under strain as pres-
sures for greater protectionism increased around the world. Three reasons caused
the rise in such pressures during the 1980s. First, the economic success of Japan
strained the world trading system. Japan was in ruins when the GATT was created.
By the early 1980s, however, it had become the world’s second-largest economy and
its largest exporter. Japan’s success in such industries as automobiles and semicon-
ductors might have been enough to strain the world trading system. Things were
made worse by the widespread perception in the West that despite low tariff rates

Smoot-Hawley Act
Enacted in 1930 by the
U.S. Congress, this tariff
erected a wall of barriers
against imports into the
United States.

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224 Part Three Cross-Border Trade and Investment

and subsidies, Japanese markets were closed to imports and foreign investment by
administrative trade barriers.
Second, the world trading system was strained by the persistent trade deficit in
the world’s largest economy, the United States. Although the deficit peaked in 1987
at more than $170 billion, by the end of 1992 the annual rate was still running about
$80 billion. From a political perspective, the matter was worsened in 1992 by the
$45 billion U.S. trade deficit with Japan, a country perceived as not playing by the
rules. The consequences of the U.S. deficit included painful adjustments in indus-
tries such as automobiles, machine tools, semiconductors, steel, and textiles, where
domestic producers steadily lost market share to foreign competitors. The resulting
unemployment gave rise to renewed demands in the U.S. Congress for protection
against imports.
A third reason for the trend toward greater protectionism was that many countries
found ways to get around GATT regulations. Bilateral voluntary export restraints, or
VERs, circumvent GATT agreements, because neither the importing country nor the
exporting country complain to the GATT bureaucracy in Geneva—and without a com-
plaint, the GATT bureaucracy can do nothing. Exporting countries agree to VERs to
avoid more damaging punitive tariffs. One of the best-known examples is the automo-
bile VER between Japan and the United States, under which Japanese producers
promised to limit their auto imports into the United States as a way of defusing grow-
ing trade tensions. According to a World Bank study, 13 percent of the imports of
industrialized countries in 1981 were subjected to nontariff trade barriers such as
VERs. By 1986, this figure had increased to 16 percent. The most rapid rise was in the
United States, where the value of imports affected by nontariff barriers (primarily
VERs) increased by 23 percent between 1981 and 1986. 30

THE URUGUAY ROUND AND THE WORLD TRADE ORGANIZATION
Against the background of rising pressures for protectionism, in 1986 GATT mem-
bers embarked on their eighth round of negotiations to reduce tariffs, the Uruguay
Round (so named because it occurred in Uruguay). This was the most difficult round
of negotiations yet, primarily because it was also the most ambitious. Until then,
GATT rules had applied only to trade in manufactured goods and commodities. In the
Uruguay Round, member countries sought to extend GATT rules to cover trade in
services. They also sought to write rules governing the protection of intellectual prop-
erty, to reduce agricultural subsidies, and to strengthen the GATT’s monitoring and
enforcement mechanisms.
The Uruguay Round dragged on for seven years before an agreement was reached
December 15, 1993. It went into effect July 1, 1995. The Uruguay Round contained
the following provisions:

1. Tariffs on industrial goods were to be reduced by more than one-third, and tariffs
were to be scrapped on more than 40 percent of manufactured goods.

2. Average tariff rates imposed by developed nations on manufactured goods were to
be reduced to less than 4 percent of value, the lowest level in modern history.

3. Agricultural subsidies were to be substantially reduced.
4. GATT fair trade and market access rules were to be extended to cover a wide

range of services.
5. GATT rules also were to be extended to provide enhanced protection for patents,

copyrights, and trademarks (intellectual property).
6. Barriers on trade in textiles were to be significantly reduced over 10 years.
7. The World Trade Organization was to be created to implement the GATT

agreement.

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Chapter Six The Political Economy of International Trade 225

Services and Intellectual Property In the long run, the extension of GATT
rules to cover services and intellectual property may be particularly significant. Until
1995, GATT rules applied only to industrial goods (i.e., manufactured goods and com-
modities). In 2007, world trade in services amounted to $3.260 billion (compared to
world trade in goods of $13,570 billion). 31 Ultimately, extension of GATT rules to this
important trading arena could significantly increase both the total share of world trade
accounted for by services and the overall volume of world trade. The extension of
GATT rules to cover intellectual property will make it much easier for high- technology
companies to do business in developing nations where intellectual property rules his-
torically have been poorly enforced (see Chapter 2 for details).

The World Trade Organization The clarification and strengthening of GATT
rules and the creation of the World Trade Organization also hold out the promise of
more effective policing and enforcement of GATT rules. The WTO acts as an um-
brella organization that encompasses the GATT along with two new sister bodies, one
on services and the other on intellectual property. The WTO’s General Agreement on
Trade in Services (GATS) has taken the lead to extending free trade agreements to
services. The WTO’s Agreement on Trade-Related Aspects of Intellectual Property
Rights (TRIPS) is an attempt to narrow the gaps in the way intellectual property
rights are protected around the world and to bring them under common international
rules. WTO has taken over responsibility for arbitrating trade disputes and monitor-
ing the trade policies of member countries. While the WTO operates on the basis of
consensus as the GATT did, in the area of dispute settlement, member countries are
no longer able to block adoption of arbitration reports. Arbitration panel reports on
trade disputes between member countries are automatically adopted by the WTO un-
less there is a consensus to reject them. Countries that have been found by the arbitra-
tion panel to violate GATT rules may appeal to a permanent appellate body, but its
verdict is binding. If offenders fail to comply with the recommendations of the arbitra-
tion panel, trading partners have the right to compensation or, in the last resort, to
impose (commensurate) trade sanctions. Every stage of the procedure is subject to
strict time limits. Thus, the WTO has something that the GATT never had—teeth. 32

WTO: Experience to Date By 2010, the WTO had 153 members, including
China, which joined at the end of 2001, who collectively account for 97 percent of
world trade. Another 25 countries, including the Russian Federation, were negotiating
for membership. Since its formation, the WTO has remained at the forefront of efforts
to promote global free trade. Its creators expressed the hope that the enforcement
mechanisms granted to the WTO would make it more effective than the GATT had
been at policing global trade rules. The great hope was that the WTO might emerge as
an effective advocate and facilitator of future trade deals, particularly in areas such as
services. The experience so far has been encouraging, although the collapse of WTO
talks in Seattle in late 1999, slow progress with the next round of trade talks (the Doha
Round), and a shift back toward some limited protectionism in 2008–2009 have raised
a number of questions about the future direction of the WTO.

WTO as Global Police The first decade in the life of the WTO suggests that its
policing and enforcement mechanisms are having a positive effect. 33 Between 1995 and
early 2010 more than 400 trade disputes between member countries were brought to
the WTO. 34 This record compares with a total of 196 cases handled by the GATT over
almost half a century. Of the cases brought to the WTO, three-fourths had been
resolved by informal consultations between the disputing countries. Resolving the
remainder has involved more formal procedures, but these have been largely successful.

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226 Part Three Cross-Border Trade and Investment

In general, countries involved have adopted the WTO’s recommendations. The fact
that countries are using the WTO represents an important vote of confidence in the
organization’s dispute resolution procedures.

Expanding Trade Agreements As explained above, the Uruguay Round of
GATT negotiations extended global trading rules to cover trade in services. The
WTO was given the role of brokering future agreements to open global trade in ser-
vices. The WTO was also encouraged to extend its reach to encompass regulations
governing foreign direct investment, something the GATT had never done. Two of
the first industries targeted for reform were the global telecommunication and finan-
cial services industries.
In February 1997, the WTO brokered a deal to get countries to agree to open
their telecommunication markets to competition, allowing foreign operators to pur-
chase ownership stakes in domestic telecommunication providers and establishing a
set of common rules for fair competition. Under the pact, 68 countries accounting for
more than 90 percent of world telecommunication revenues pledged to start opening
their markets to foreign competition and to abide by common rules for fair competi-
tion in telecommunications. Most of the world’s biggest markets, including the
United States, European Union, and Japan, were fully liberalized by January 1, 1998,
when the pact went into effect. All forms of basic telecommunication service are cov-
ered, including voice telephony, data and fax transmissions, and satellite and radio
communications. Many telecommunication companies responded positively to the
deal, pointing out that it would give them a much greater ability to offer their busi-
ness customers one-stop shopping—a global, seamless service for all their corporate
needs and a single bill. 35
This was followed in December 1997 with an agreement to liberalize cross-border
trade in financial services. 36 The deal covers more than 95 percent of the world’s
financial services market. Under the agreement, which took effect at the beginning of
March 1999, 102 countries pledged to open to varying degrees their banking, securi-
ties, and insurance sectors to foreign competition. In common with the telecommuni-
cation deal, the accord covers not just cross-border trade but also foreign direct
investment. Seventy countries agreed to dramatically lower or eradicate barriers to
foreign direct investment in their financial services sector. The United States and the
European Union, with minor exceptions, are fully open to inward investment by for-
eign banks, insurance, and securities companies. As part of the deal, many Asian coun-

tries made important concessions that allow
significant foreign participation in their financial ser-
vices sectors for the first time.

The WTO in Seattle: A Watershed? At the
end of November 1999, representatives from the
WTO’s member states met in Seattle, Washington.
The goal of the meeting was to launch a new round
of talks—dubbed “the millennium round”—aimed at
further reducing barriers to cross-border trade and
investment. Prominent on the agenda was an attempt
to get the assembled countries to agree to work to-
ward the reduction of barriers to cross-border trade
in agricultural products and trade and investment in
services.

These expectations were dashed on the rocks of
a hard and unexpected reality. The talks ended

WTO protesters gather in front of the Niketown store at Fifth Avenue and
Pike Street in downtown Seattle before the opening of the WTO session
in 1999.

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Chapter Six The Political Economy of International Trade 227

December 3, 1999, without any agreement being reached. Inside the meeting rooms,
the problem was an inability to reach consensus on the primary goals for the next
round of talks. A major stumbling block was friction between the United States and
the European Union over whether to endorse the aim of ultimately eliminating subsi-
dies to agricultural exporters. The United States wanted the elimination of such sub-
sidies to be a priority. The EU, with its politically powerful farm lobby and long
history of farm subsidies, was unwilling to take this step. Another stumbling block was
related to efforts by the United States to write “basic labor rights” into the law of the
world trading system. The United States wanted the WTO to allow governments to
impose tariffs on goods imported from countries that did not abide by what the United
States saw as fair labor practices. Representatives from developing nations reacted an-
grily to this proposal, suggesting it was simply an attempt by the United States to find
a legal way of restricting imports from poorer nations.
While the disputes inside the meeting rooms were acrimonious, it was events out-
side that captured the attention of the world press. The WTO talks proved to be a
lightning rod for a diverse collection of organizations from environmentalists and
human rights groups to labor unions. For various reasons, these groups oppose free
trade. All these organizations argued that the WTO is an undemocratic institution
that was usurping the national sovereignty of member states and making decisions of
great importance behind closed doors. They took advantage of the Seattle meetings to
voice their opposition, which the world press recorded.
Environmentalists expressed concern about the impact that free trade in agricul-
tural products might have on the rate of global deforestation. They argued that lower
tariffs on imports of lumber from developing nations will stimulate demand and
accelerate the rate at which virgin forests are logged, particularly in nations such as
Malaysia and Indonesia. They also pointed to the adverse impact that some WTO
rulings have had on environmental policies. For example, the WTO had blocked a
U.S. rule that ordered shrimp nets be equipped with a device that allows endangered
sea turtles to escape. The WTO found the rule discriminated against foreign import-
ers who lacked such nets. 37 Environmentalists argued that the rule was necessary to
protect the turtles from extinction.
Human rights activists see WTO rules as outlawing the ability of nations to stop
imports from countries where child labor is used or working conditions are hazardous.
Similarly, labor unions oppose trade laws that allow imports from low-wage countries
and result in a loss of jobs in high-wage countries. They buttress their position by
arguing that American workers are losing their jobs to imports from developing
nations that do not have adequate labor standards.
Supporters of the WTO and free trade dismiss these concerns. They have repeat-
edly pointed out that the WTO exists to serve the interests of its member states, not
subvert them. The WTO lacks the ability to force any member nation to take an
action to which it is opposed. The WTO can allow member nations to impose retalia-
tory tariffs on countries that do not abide by WTO rules, but that is the limit of its
power. Furthermore, supporters argue, it is rich countries that pass strict environmen-
tal laws and laws governing labor standards, not poor ones. In their view, free trade, by
raising living standards in developing nations, will be followed by the passage of such
laws in these nations. Using trade regulations to try to impose such practices on devel-
oping nations, they believe, will produce a self-defeating backlash.
Many representatives from developing nations, which make up about 70 percent
of the WTO’s members, also reject the position taken by environmentalists and advo-
cates of human and labor rights. Poor countries, which depend on exports to boost
their economic growth rates and work their way out of poverty, fear that rich coun-
tries will use environmental concerns, human rights, and labor-related issues to erect

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228 Part Three Cross-Border Trade and Investment

barriers to the products of the developing world. They believe that attempts to incor-
porate language about the environment or labor standards in future trade agreements
will amount to little more than trade barriers by another name. 38 If this were to oc-
cur, they argue that the effect would be to trap the developing nations of the world in
a grinding cycle of poverty and debt.
These pro-trade arguments fell on deaf ears. As the WTO representatives gathered
in Seattle, environmentalists, human rights activists, and labor unions marched in the
streets. Some of the more radical elements in these organizations, together with
groups of anarchists who were philosophically opposed to “global capitalism” and “the
rape of the world by multinationals,” succeeded not only in shutting down the opening
ceremonies of the WTO but also in sparking violence in the normally peaceful streets
of Seattle. A number of demonstrators damaged property and looted; and the police
responded with tear gas, rubber bullets, pepper spray, and baton charges. When it was
over, 600 demonstrators had been arrested, millions of dollars in property had been
damaged in downtown Seattle, and the global news media had their headline: “WTO
Talks Collapse amid Violent Demonstrations.”
What happened in Seattle is notable because it may have been a watershed of sorts.
In the past, previous trade talks were pursued in relative obscurity with only interested
economists, politicians, and businesspeople paying much attention. Seattle demon-
strated that the issues surrounding the global trend toward free trade have moved to
center stage in the popular consciousness, and they have remained there since. The
debate on the merits of free trade and globalization has become mainstream. Whether
further liberalization occurs, therefore, may depend on the importance that popular
opinion in countries such as the United States attaches to issues such as human rights
and labor standards, job security, environmental policies, and national sovereignty. It
will also depend on the ability of advocates of free trade to articulate in a clear and
compelling manner the argument that, in the long run, free trade is the best way of
promoting adequate labor standards, of providing more jobs, and of protecting the
environment.

THE FUTURE OF THE WTO: UNRESOLVED ISSUES AND THE
DOHA ROUND Much remains to be done on the international trade front. Four
issues at the forefront of the current agenda of the WTO are the increase in anti-
dumping policies, the high level of protectionism in agriculture, the lack of strong
protection for intellectual property rights in many nations, and continued high tariff
rates on nonagricultural goods and services in many nations. We shall look at each in
turn before discussing the latest round of talks between WTO members aimed at
reducing trade barriers, the Doha Round, which began in 2001 and were still ongoing
as of 2010.

Antidumping Actions Antidumping actions proliferated during the 1990s. WTO
rules allow countries to impose antidumping duties on foreign goods that are being
sold cheaper than at home, or below their cost of production, when domestic produc-
ers can show that they are being harmed. Unfortunately, the rather vague definition of
what constitutes “dumping” has proved to be a loophole that many countries are ex-
ploiting to pursue protectionism.
Between 1995 and 2008, WTO members had reported implementation of some
3,427 antidumping actions to the WTO. India initiated the largest number of anti-
dumping actions, some 564; the EU initiated 391 over the same period, and the United
States 418 (see Figure 6.2). Antidumping actions seem to be concentrated in certain
sectors of the economy such as basic metal industries (e.g., aluminum and steel),
chemicals, plastics, and machinery and electrical equipment. 39 These sectors account

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Chapter Six The Political Economy of International Trade 229

for some 70 percent of all antidumping actions reported to the WTO. These four sec-
tors since 1995 have been characterized by periods of intense competition and excess
productive capacity, which have led to low prices and profits (or losses) for firms in
those industries. It is not unreasonable, therefore, to hypothesize that the high level of
antidumping actions in these industries represents an attempt by beleaguered manu-
facturers to use the political process in their nations to seek protection from foreign
competitors, who they claim are engaging in unfair competition. While some of these
claims may have merit, the process can become very politicized as representatives of
businesses and their employees lobby government officials to “protect domestic jobs
from unfair foreign competition,” and government officials, mindful of the need to get
votes in future elections, oblige by pushing for antidumping actions. The WTO is
clearly worried by this trend, suggesting that it reflects persistent protectionist ten-
dencies and pushing members to strengthen the regulations governing the imposition
of antidumping duties.
Figure 6.2 suggests that antidumping actions peaked in the 1999-2001 time period
and declined thereafter. However, the WTO reported a rise in antidumping actions in
2008 and 2009 as the global financial crisis took hold (the 2009 data are not included
in Figure 6.2, since at the time of writing the data had not been finalized). Many of
these actions seem to have been a direct response to the decline in global demand that
followed the financial crisis and suggest that countries were using antidumping actions
as a means of protecting domestic producers. The most frequent target of these ac-
tions was China.

Protectionism in Agriculture Another recent focus of the WTO has been the
high level of tariffs and subsidies in the agricultural sector of many economies. Tariff
rates on agricultural products are generally much higher than tariff rates on manufac-
tured products or services. For example, in the mid-2000s the average tariff rates on
nonagricultural products were 4.2 percent for Canada, 3.8 percent for the European
Union, 3.9 percent for Japan, and 4.4 percent for the United States. On agricultural
products, however, the average tariff rates were 21.2 percent for Canada, 15.9 percent
for the European Union, 18.6 percent for Japan, and 10.3 percent for the United

400

100

150

200

250

300

350

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 20062005 2007 2008

Rest of the WorldUnited StatesIndiaEuropean Community

N
um

be
r o

f a
gr

ee
m

en
ts

6.2 figure

Antidumping Actions,
1995–2008

Source: Constructed by author from
WTO data.

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230 Part Three Cross-Border Trade and Investment

States. 40 The implication is that consumers in these
countries are paying significantly higher prices
than necessary for agricultural products imported
from abroad, which leaves them with less money to
spend on other goods and services.

The historically high tariff rates on agricultural
products reflect a desire to protect domestic agri-
culture and traditional farming communities from
foreign competition. In addition to high tariffs, ag-
ricultural producers also benefit from substantial
subsidies. According to estimates from the Organi-
zation for Economic Cooperation and Develop-
ment (OECD), government subsidies on average
account for some 17 percent of the cost of agricul-
tural production in Canada, 21 percent in the
United States, 35 percent in the European Union,
and 59 percent in Japan. 41 In total, OECD coun-
tries spend more than $300 billion a year in subsi-
dies to agricultural producers.

Not surprising, the combination of high tariff
barriers and significant subsidies introduces sig-

nificant distortions into the production of agricultural products and international
trade of those products. The net effect is to raise prices to consumers, reduce the
volume of agricultural trade, and encourage the overproduction of products that are
heavily subsidized (with the government typically buying the surplus). Because global
trade in agriculture currently amounts to 10.5 percent of total merchandized trade,
or about $750 billion per year, the WTO argues that removing tariff barriers and
subsidies could significantly boost the overall level of trade, lower prices to consum-
ers, and raise global economic growth by freeing consumption and investment re-
sources for more productive uses. According to estimates from the International
Monetary Fund, removal of tariffs and subsidies on agricultural products would raise
global economic welfare by $128 billion annually. 42 Others suggest gains as high as
$182 billion. 43
The biggest defenders of the existing system have been the advanced nations of the
world, which want to protect their agricultural sectors from competition by low-cost
producers in developing nations. In contrast, developing nations have been pushing
hard for reforms that would allow their producers greater access to the protected mar-
kets of the developed nations. Estimates suggest that removing all subsidies on agri-
cultural production alone in OECD countries could return to the developing nations
of the world three times more than all the foreign aid they currently receive from the
OECD nations. 44 In other words, free trade in agriculture could help to jump-start
economic growth among the world’s poorer nations and alleviate global poverty.

Protecting Intellectual Property Another issue that has become increasingly
important to the WTO has been protecting intellectual property. The 1995 Uru-
guay agreement that established the WTO also contained an agreement to protect
intellectual property (the Trade-Related Aspects of Intellectual Property Rights, or
TRIPS, agreement). The TRIPS regulations oblige WTO members to grant and
enforce patents lasting at least 20 years and copyrights lasting 50 years. Rich coun-
tries had to comply with the rules within a year. Poor countries, in which such pro-
tection generally was much weaker, had five years’ grace, and the very poorest had

Another Per spect i ve

Brazil Wins against U.S. Cotton
The United States is known for aggressively protecting its
agriculture from overseas competition, but this time it may
carry a cost.
Claiming for years U.S. subsidies drove down cotton
prices worldwide, Brazil recently won its suit against the
United States before the World Trade Organization (WTO).
Not only does the WTO ruling permit Brazil to retaliate
against the United States, but it also apparently gives Brazil
the right to breach U.S. patents. Accordingly, Brazil said it
would impose higher tariffs on U.S. goods totaling nearly
$830 million per year, with about $240 million targeting intel-
lectual property. That’s likely to hit America where it lives.
(“Brazil Takes on Washington,” Forbes, March 26, 2010,
www.forbes.com; “Brazil, U.S.: An Intellectual Property
Precedent,” Stratfor.com, February 11, 2010, www.stratfor.
com; and Steve LeVine, “Brazil Bests U.S. in Cotton Battle,”
BusinessWeek, August 31, 2009, www.businessweek.com)

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Chapter Six The Political Economy of International Trade 231

10 years. The basis for this agreement was a strong belief among signatory nations
that the protection of intellectual property through patents, trademarks, and copy-
rights must be an essential element of the international trading system. Inadequate
protections for intellectual property reduce the incentive for innovation. Because
innovation is a central engine of economic growth and rising living standards, the
argument has been that a multilateral agreement is needed to protect intellectual
property.
Without such an agreement it is feared that producers in a country, let’s say India,
might market imitations of patented innovations pioneered in a different country, say
the United States. This can affect international trade in two ways. First, it reduces the
export opportunities in India for the original innovator in the United States. Second,
to the extent that the Indian producer is able to export its pirated imitation to addi-
tional countries, it also reduces the export opportunities in those countries for the U.S.
inventor. Also, one can argue that because the size of the total world market for the
innovator is reduced, its incentive to pursue risky and expensive innovations is also
reduced. The net effect would be less innovation in the world economy and less eco-
nomic growth.
Something very similar to this has been occurring in the pharmaceutical industry,
with Indian drug companies making copies of patented drugs discovered elsewhere. In
1970, the Indian government stopped recognizing product patents on drugs, but it
elected to continue respecting process patents. This permitted Indian companies to
reverse-engineer Western pharmaceuticals without paying licensing fees. As a result,
foreigners’ share of the Indian drug market fell from 75 percent in 1970 to 30 percent
in 2000. For example, an Indian company sells a version of Bayer’s patented antibiotic
Cipro for $0.12 a pill, versus the $5.50 it costs in the United States. Under the WTO
TRIPS agreement, India agreed to adopt and enforce the international drug patent
regime by 2005. 45
As noted in Chapter 2, intellectual property rights violation is also an endemic
problem in several other industries, most notably computer software and music. The
WTO believes that reducing piracy rates in areas such as drugs, software, and music
recordings would have a significant impact on the volume of world trade and increase
the incentive for producers to invest in the creation of intellectual property. A world
without piracy would have more new drugs, computer software, and music recordings
produced every year. In turn, this would boost economic and social welfare, and
global economic growth rates. It is thus in the interests of WTO members to make
sure that intellectual property rights are respected and enforced. While the 1995
Uruguay agreement that created the WTO did make headway with the TRIPS agree-
ment, some believe these requirements do not go far enough and further commit-
ments are necessary.

Market Access for Nonagricultural Goods and Services Although the
WTO and the GATT have made big strides in reducing the tariff rates on nonagricul-
tural products, much work remains. Although most developed nations have brought
their tariff rates on industrial products down to an average of 3.8 percent of value,
exceptions still remain. In particular, while average tariffs are low, high tariff rates per-
sist on certain imports into developed nations, which limit market access and eco-
nomic growth. For example, Australia and South Korea, both OECD countries, still
have bound tariff rates of 15.1 percent and 24.6 percent, respectively, on imports of
transportation equipment (bound tariff rates are the highest rate that can be charged,
which is often, but not always, the rate that is charged). In contrast, the bound tariff
rates on imports of transportation equipment into the United States, EU, and Japan

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232 Part Three Cross-Border Trade and Investment

are 2.7 percent, 4.7 percent, and 0 percent, respectively (see Table 6.1). A particular
area for concern is high tariff rates on imports of selected goods from developing na-
tions into developed nations.
In addition, tariffs on services remain higher than on industrial goods. The average
tariff on business and financial services imported into United States, for example, is
8.2 percent, into the EU it is 8.5 percent, and into Japan it is 19.7 percent. 46 Given the
rising value of cross-border trade in services, reducing these figures can be expected to
yield substantial gains.
The WTO would like to bring down tariff rates still further and reduce the scope
for the selective use of high tariff rates. The ultimate aim is to reduce tariff rates to
zero. Although this might sound ambitious, 40 nations have already moved to zero
tariffs on information technology goods, so a precedent exists. Empirical work sug-
gests that further reductions in average tariff rates toward zero would yield substantial
gains. One estimate by economists at the World Bank suggests that a broad global
trade agreement coming out of the current Doha negotiations could increase world
income by $263 billion annually, of which $109 billion would go to poor countries. 47
Another estimate from the OECD suggests a figure closer to $300 billion annually. 48
See the accompanying Country Focus for estimates of the benefits to the American
economy from free trade.
Looking further out, the WTO would like to bring down tariff rates on imports of
nonagricultural goods into developing nations. Many of these nations use the infant
industry argument to justify the continued imposition of high tariff rates; however,
ultimately these rates need to come down for these nations to reap the full benefits of
international trade. For example, the bound tariff rates of 53.9 percent on imports of
transportation equipment into India and 33.6 percent on imports into Brazil, by rais-
ing domestic prices, help to protect inefficient domestic producers and limit economic
growth by reducing the real income of consumers who must pay more for transporta-
tion equipment and related services.

A New Round of Talks: Doha Antidumping actions, trade in agricultural
products, better enforcement of intellectual property laws, and expanded market
access were four of the issues the WTO wanted to tackle at the 1999 meetings in
Seattle, but those meetings were derailed. In late 2001, the WTO tried again to
launch a new round of talks between member states aimed at further liberalizing
the global trade and investment framework. For this meeting, it picked the remote
location of Doha in the Persian Gulf state of Qatar, no doubt with an eye on the

Canada 2.8% 6.8% 5.2%

United States 1.8 2.7 2.1

Brazil 33.4 33.6 31.9

Mexico 34.7 35.8 34.1

European Union 1.6 4.7 3.3

Australia 4.5 15.1 13.3

Japan 0.9 0.0 0.2

South Korea 7.7 24.6 16.1

Country Metals Transportation Equipment Electric Machinerytable 6.1

Bound Tariffs on Select
Industrial Products

(simple averages)

Source: WTO.

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Chapter Six The Political Economy of International Trade 233

difficulties that antiglobalization protesters would have in getting there. Unlike the
Seattle meetings, at Doha, the member states of the WTO agreed to launch a new
round of talks and staked out an agenda. The talks were originally scheduled to last
three years, although they have already gone on longer and may not be concluded
for a while.
The agenda includes cutting tariffs on industrial goods and services, phasing out
subsidies to agricultural producers, reducing barriers to cross-border investment,
and limiting the use of antidumping laws. Some difficult compromises were made
to reach agreement on this agenda. The EU and Japan had to give significant
ground on the issue of agricultural subsidies, which are used extensively by both
entities to support politically powerful farmers. The United States bowed to pres-
sure from virtually every other nation to negotiate revisions of antidumping rules,
which the United States has used extensively to protect its steel producers from
foreign competition. Europe had to scale back its efforts to include environmental
policy in the trade talks, primarily because of pressure from developing nations that
see environmental protection policies as trade barriers by another name. Excluded
from the agenda was any language pertaining to attempts to tie trade to labor stan-
dards in a country.
Countries with big pharmaceutical sectors acquiesced to demands from African,
Asian, and Latin American nations on the issue of drug patents. Specifically, the lan-
guage in the agreement declares that WTO regulation on intellectual property “does
not and should not prevent members from taking measures to protect public health.”
This language was meant to assure the world’s poorer nations that they can make or
buy generic equivalents to fight such killers as AIDS and malaria.

Estimating the Gains from Trade for America

A study published by the Institute for International Eco-
nomics tried to estimate the gains to the American econ-
omy from free trade. According to the study, due to
reductions in tariff barriers under the GATT and WTO since
1947, by 2003 the GDP of the United States was 7.3 percent
higher than would otherwise be the case. The benefits of
that amount to roughly $1 trillion a year, or $9,000 extra
income for each American household per year.
The same study tried to estimate what would happen if
America reached free trade deals with all its trading part-
ners, reducing tariff barriers on all goods and services to
zero. Using several methods to estimate the impact, the
study concluded that additional annual gains of between
$450 billion and $1.3 trillion could be realized. This final
march to free trade, according to the authors of the study,
could safely be expected to raise incomes of the average
American household by an additional $4,500 per year.
The authors also tried to estimate the scale and cost of
employment disruption that would be caused by a move to
universal free trade. Jobs would be lost in certain sectors

and gained in others if the country abolished all tariff
barriers. Using historical data as a guide, they estimated
that 226,000 jobs would be lost every year due to expanded
trade, although some two-thirds of those losing jobs would
find reemployment after a year. Reemployment, however,
would be at a wage that was 13 to 14 percent lower. The
study concluded that the disruption costs would total some
$54 billion annually, primarily in the form of lower lifetime
wages to those whose jobs were disrupted as a result of
free trade. Offset against this, however, must be the higher
economic growth resulting from free trade, which creates
many new jobs and raises household incomes, creating
another $450 billion to $1.3 trillion annually in net gains to
the economy. In other words, the estimated annual gains
from trade are far greater than the estimated annual costs
associated with job disruption, and more people benefit
than lose as result of shift to a universal free trade regime.

Source: S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer, “The Payoff to
America from Global Integration,” in The United States and the World
Economy: Foreign Policy for the Next Decade, ed. C. F. Bergsten
(Washington, DC: Institute for International Economics, 2005).

3 Country FOCUS

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234 Part Three Cross-Border Trade and Investment

Focus on Managerial Implications

What are the implications of all this for business practice? Why should the interna-
tional manager care about the political economy of free trade or about the relative
merits of arguments for free trade and protectionism? There are two answers to this
question. The first concerns the impact of trade barriers on a firm’s strategy. The
second concerns the role that business firms can play in promoting free trade or
trade barriers.

Trade Barriers and Firm Strategy
To understand how trade barriers affect a firm’s strategy, consider first the material in
Chapter 5. Drawing on the theories of international trade, we discussed how it makes
sense for the firm to disperse its various production activities to those countries around
the globe where they can be performed most efficiently. Thus, it may make sense for a

Clearly, it is one thing to agree to an agenda and quite another to reach a consensus
on a new treaty. Nevertheless, if an agreement is reached there are some clear poten-
tial winners. These include low-cost agricultural producers in the developing world
and developed nations such as Australia and the United States. If the talks are success-
ful, agricultural producers in these nations will ultimately see the global markets for
their goods expand. Developing nations also gain from the lack of language on labor
standards, which many saw as an attempt by rich nations to erect trade barriers. The
sick and poor of the world also benefit from guaranteed access to cheaper medicines.
There are also clear losers in this agreement, including EU and Japanese farmers, U.S.
steelmakers, environmental activists, and pharmaceutical firms in the developed world.
These losers can be expected to lobby their governments hard during the ensuing
years to make sure that the final agreement is more in their favor. 49 In general, though,
if ultimately successful, the Doha Round of negotiations could significantly raise
global economic welfare. As noted above, estimates suggest that a successful Doha
Round would raise global incomes by as much as $300 billion annually, with 60 per-
cent of the gain going to the world’s poorer nations, which would help to pull 150
million people out of poverty. 50
The talks are currently ongoing, and as seems normal in these cases, they are
characterized by halting progress punctuated by significant setbacks and missed
deadlines. A September 2003 meeting in Cancun, Mexico, broke down, primarily
because there was no agreement on how to proceed with reducing agricultural sub-
sidies and tariffs; the EU, United States, and India, among others, proved less than
willing to reduce tariffs and subsidies to their politically important farmers, while
countries such as Brazil and certain West African nations wanted free trade as
quickly as possible. In 2004, both the United States and the EU made a determined
push to start the talks again. However, since then little progress has been made and
the talks are in deadlock, primarily because of disagreements over how deep the cuts
in subsidies to agricultural produces should be. As of early 2010, the goal was to
reduce tariffs for manufactured and agricultural goods by 60 to 70 percent, and to
cut subsidies to half of their current level, but getting nations to agree to these goals
was proving exceedingly difficult.

LEARNING OBJECTIVE 5
Explain the implications for
managers of developments
in the world trading system.

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Chapter Six The Political Economy of International Trade 235

firm to design and engineer its product in one country, to manufacture components in
another, to perform final assembly operations in yet another country, and then export
the finished product to the rest of the world.
Clearly, trade barriers constrain a firm’s ability to disperse its productive activi-
ties in such a manner. First and most obvious, tariff barriers raise the costs of ex-
porting products to a country (or of exporting partly finished products between
countries). This may put the firm at a competitive disadvantage to indigenous com-
petitors in that country. In response, the firm may then find it economical to locate
production facilities in that country so that it can compete on an even footing. Sec-
ond, quotas may limit a firm’s ability to serve a country from locations outside of
that country. Again, the response by the firm might be to set up production facilities
in that country—even though it may result in higher production costs. Such reason-
ing was one of the factors behind the rapid expansion of Japanese automaking
capacity in the United States during the 1980s and 1990s. This followed the estab-
lishment of a VER agreement between the United States and Japan that limited
U.S. imports of Japanese automobiles.
Third, to conform to local content regulations, a firm may have to locate more
production activities in a given market than it would otherwise. Again, from the firm’s
perspective, the consequence might be to raise costs above the level that could be
achieved if each production activity was dispersed to the optimal location for that
activity. And finally, even when trade barriers do not exist, the firm may still want to
locate some production activities in a given country to reduce the threat of trade bar-
riers being imposed in the future.
All these effects are likely to raise the firm’s costs above the level that could be
achieved in a world without trade barriers. The higher costs that result need not
translate into a significant competitive disadvantage relative to other foreign firms,
however, if the countries imposing trade barriers do so to the imported products of
all foreign firms, irrespective of their national origin. But when trade barriers are
targeted at exports from a particular nation, firms based in that nation are at a com-
petitive disadvantage to firms of other nations. The firm may deal with such targeted
trade barriers by moving production into the country imposing barriers. Another
strategy may be to move production to countries whose exports are not targeted by
the specific trade barrier.
Finally, the threat of antidumping action limits the ability of a firm to use ag-
gressive pricing to gain market share in a country. Firms in a country also can make
strategic use of antidumping measures to limit aggressive competition from low-
cost foreign producers. For example, the U.S. steel industry has been very aggres-
sive in bringing antidumping actions against foreign steelmakers, particularly in
times of weak global demand for steel and excess capacity. In 1998 and 1999, the
United States faced a surge in low-cost steel imports as a severe recession in Asia
left producers there with excess capacity. The U.S. producers filed several com-
plaints with the International Trade Commission. One argued that Japanese pro-
ducers of hot rolled steel were selling it at below cost in the United States. The
ITC agreed and levied tariffs ranging from 18 percent to 67 percent on imports of
certain steel products from Japan (these tariffs are separate from the steel tariffs
discussed earlier).51

Policy Implications
As noted in Chapter 5, business firms are major players on the international trade
scene. Because of their pivotal role in international trade, firms can and do exert a
strong influence on government policy toward trade. This influence can encourage
protectionism or it can encourage the government to support the WTO and push for

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236 Part Three Cross-Border Trade and Investment

free trade, p. 204
tariff, p. 206
specific tariff, p. 206
ad valorem tariff, p. 206
subsidy, p. 207
import quota, p. 208
tariff rate quota, p. 209

voluntary export restraint
(VER) , p. 209
quota rent, p. 210
local content requirement, p. 210
administrative trade policies, p. 210
dumping, p. 211
antidumping policies, p. 211

countervailing duties, p. 211
Helms-Burton Act, p. 216
D’Amato Act, p. 216
infant industry argument, p. 219
strategic trade policy, p. 220
Smoot-Hawley Act, p. 223

Key Terms

open markets and freer trade among all nations. Government policies with regard to
international trade can have a direct impact on business.
Consistent with strategic trade policy, examples can be found of government in-
tervention in the form of tariffs, quotas, antidumping actions, and subsidies helping
firms and industries establish a competitive advantage in the world economy. In
general, however, the arguments contained in this chapter and in Chapter 5 suggest
that government intervention has three drawbacks. Intervention can be self-defeating
because it tends to protect the inefficient rather than help firms become efficient
global competitors. Intervention is dangerous; it may invite retaliation and trigger a
trade war. Finally, intervention is unlikely to be well executed, given the opportunity
for such a policy to be captured by special-interest groups. Does this mean that
business should simply encourage government to adopt a laissez-faire free trade
policy?
Most economists would probably argue that the best interests of international busi-
ness are served by a free trade stance, but not a laissez-faire stance. It is probably in the
best long-run interests of the business community to encourage the government to
aggressively promote greater free trade by, for example, strengthening the WTO.
Business probably has much more to gain from government efforts to open protected
markets to imports and foreign direct investment than from government efforts to
support certain domestic industries in a manner consistent with the recommendations
of strategic trade policy.
This conclusion is reinforced by a phenomenon we touched on in Chapter 1—the
increasing integration of the world economy and internationalization of produc-
tion that has occurred over the past two decades. We live in a world where many
firms of all national origins increasingly depend for their competitive advantage on
globally dispersed production systems. Such systems are the result of freer trade.
Freer trade has brought great advantages to firms that have exploited it and to con-
sumers who benefit from the resulting lower prices. Given the danger of retaliatory
action, business firms that lobby their governments to engage in protectionism
must realize that by doing so they may be denying themselves the opportunity to
build a competitive advantage by constructing a globally dispersed production sys-
tem. By encouraging their governments to engage in protectionism, their own ac-
tivities and sales overseas may be jeopardized if other governments retaliate. This
does not mean a firm should never seek protection in the form of antidumping ac-
tions and the like, but it should review its options carefully and think through the
larger consequences.

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Chapter Six The Political Economy of International Trade 237

Summary
The goal of this chapter was to describe how the
reality of international trade deviates from the theo-
retical ideal of unrestricted free trade reviewed in
Chapter 5. In this chapter, we have reported the
various instruments of trade policy, reviewed the
political and economic arguments for government
intervention in international trade, reexamined the
economic case for free trade in light of the strategic
trade policy argument, and looked at the evolution
of the world trading framework. While a policy of
free trade may not always be the theoretically opti-
mal policy (given the arguments of the new trade
theorists), in practice it is probably the best policy
for a government to pursue. In particular, the long-
run interests of business and consumers may be best
served by strengthening international institutions
such as the WTO. Given the danger that isolated
protectionism might escalate into a trade war, busi-
ness probably has far more to gain from government
efforts to open protected markets to imports and
foreign direct investment (through the WTO) than
from government efforts to protect domestic indus-
tries from foreign competition. The chapter made
the following points:

1. Trade policies, such as tariffs, subsidies,
antidumping regulations, and local content
requirements tend to be pro-producer and
anti-consumer. Gains accrue to producers
(who are protected from foreign competitors),
but consumers lose because they must pay
more for imports.

2. There are two types of arguments for
government intervention in international trade:
political and economic. Political arguments for
intervention are concerned with protecting the
interests of certain groups, often at the expense
of other groups, or with promoting goals with
regard to foreign policy, human rights,
consumer protection, and the like. Economic
arguments for intervention are about boosting
the overall wealth of a nation.

3. A common political argument for intervention
is that it is necessary to protect jobs. However,
political intervention often hurts consumers
and it can be self-defeating. Countries
sometimes argue that it is important to protect
certain industries for reasons of national
security. Some argue that government should

use the threat to intervene in trade policy as a
bargaining tool to open foreign markets. This
can be a risky policy; if it fails, the result can be
higher trade barriers.

4. The infant industry argument for government
intervention contends that to let manufacturing
get a toehold, governments should temporarily
support new industries. In practice, however,
governments often end up protecting the
inefficient.

5. Strategic trade policy suggests that with
subsidies, government can help domestic firms
gain first-mover advantages in global industries
where economies of scale are important.
Government subsidies may also help domestic
firms overcome barriers to entry into such
industries.

6. The problems with strategic trade policy are
twofold: (a) such a policy may invite retaliation,
in which case all will lose, and (b) strategic
trade policy may be captured by special-
interest groups, which will distort it to their
own ends.

7. The GATT was a product of the postwar free
trade movement. The GATT was successful in
lowering trade barriers on manufactured goods
and commodities. The move toward greater
free trade under the GATT appeared to
stimulate economic growth.

8. The completion of the Uruguay Round of
GATT talks and the establishment of the
World Trade Organization have strengthened
the world trading system by extending GATT
rules to services, increasing protection for
intellectual property, reducing agricultural
subsidies, and enhancing monitoring and
enforcement mechanisms.

9. Trade barriers act as a constraint on a firm’s
ability to disperse its various production
activities to optimal locations around the globe.
One response to trade barriers is to establish
more production activities in the protected
country.

10. Business may have more to gain from
government efforts to open protected markets
to imports and foreign direct investment than
from government efforts to protect domestic
industries from foreign competition.

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238 Part Three Cross-Border Trade and Investment

Why Did Global Food Prices Rise?

For a quarter of a century, global food prices had been falling,
driven by the increased productivity and output of the farm
sector worldwide. In 2007, this came to an abrupt end as global
food prices soared. By September 2007, the world price of
wheat rose to more than $400 a ton—the highest ever recorded
and up from $200 a ton in May. The price of corn (maize) surged
to $175 a ton, some 60 percent above its average for 2006. An

index of food prices, which The Economist magazine has kept
since 1845 and is adjusted for inflation, hit its highest level ever
in December 2007!
One explanation for rising food prices has been increased
demand. The increased demand has been driven by greater
food consumption in rapidly developing nations, most notably
China and India. Rising consumption of meat, in particular,

closing case

Critical Thinking and Discussion Questions
1. Do you think governments should consider

human rights when granting preferential trading
rights to countries? What are the arguments for
and against taking such a position?

2. Whose interests should be the paramount
concern of government trade policy—the
interests of producers (businesses and their
employees) or those of consumers?

3. Given the arguments relating to the new trade
theory and strategic trade policy, what kind of
trade policy should business be pressuring
government to adopt?

4. You are an employee of a U.S. firm that produces
personal computers in Thailand and then
exports them to the United States and other
countries for sale. The personal computers were
originally produced in Thailand to take

advantage of relatively low labor costs and a
skilled workforce. Other possible locations
considered at the time were Malaysia and Hong
Kong. The U.S. government decides to impose
punitive 100 percent ad valorem tariffs on
imports of computers from Thailand to punish
the country for administrative trade barriers that
restrict U.S. exports to Thailand. How should
your firm respond? What does this tell you
about the use of targeted trade barriers?

5. Reread the Management Focus “U.S.
Magnesium Seeks Protection.” Who gains most
from the antidumping duties levied by the
United States on imports of magnesium from
China and Russia? Who are the losers? Are
these duties in the best national interests of the
United States?

Use the globalEDGE Resource Desk (http://
globalEDGE.msu.edu/resourcedesk/) to complete
the following exercises:

1. Your company is considering exporting its
pharmaceutical products to Japan, but
management’s current knowledge of the
country’s trade policies and barriers for this
sector is limited. Conduct the appropriate level
of research in a trade barriers database to identify
any information on Japan’s current standards and
technical requirements for pharmaceutical

products. Prepare an executive summary of your
findings.

2. You work for a national chain of clothing stores
that is considering importing textiles from India
into the United States. You want to determine
whether the goods are subject to import quotas.
Using information provided by the U.S. Customs
and Border Protections, prepare a report
highlighting the elements that determine
whether a shipment is subject to this type of
trade restriction.

Research Task http://globalEDGE.msu.edu

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Chapter Six The Political Economy of International Trade 239

has driven up demand for grains; it takes eight kilograms of
cereals to produce one kilogram of beef, so as demand for
meat rises, consumption of grains by cattle surges. Farmers
now feed 200 million to 250 million more tons of grain to their
animals than they did 20 years ago, driving up grain prices.
Then there is the issue of biofuel subsidies. Both the United
States and the European Union have adopted policies to
increase production of ethanol and biodiesel to slow global
warming (both products are argued to produce fewer CO2 emis-
sions, although how effective they are at doing this is actively
debated). In 2000, about 15 million tons of American corn was
turned into ethanol; in 2007 the figure reached 85 million tons. To
promote increased production, governments have given subsi-
dies to farmers. In the United States, subsidies amount to
between $0.29 and $0.36 per liter of ethanol. In Europe, the sub-
sidies are as high as $1 a liter. Not surprisingly, the subsidies
have created an incentive for farmers to plant more crops that
can be turned into biofuels (primarily corn and soybeans). This
has diverted land away from production of corn and soy for food
and reduced the supply of land devoted to growing crops that
don’t receive biofuel subsidies, such as wheat. This highly sub-
sidized source of demand seems to be having a dramatic effect
on demand for corn and soybeans. In 2007, for example, the U.S.
increase in demand for corn-based ethanol accounted for more
than half of the global increase in demand for corn.
Complicating the situation are the high tariffs that shut
producers of alternative products that can be turned into bio-
fuels, most notably sugar cane, out of the American and EU
markets. Brazil, the world’s most efficient producer of sugar
cane, confronts import tariffs of at least 25 percent by value in
the United States and 50 percent in the EU, raising the price
of imported sugar cane and making it uncompetitive with
subsidized corn and soybeans. This is unfortunate because
sugar cane is widely seen as a more environmentally friendly
raw material for biofuels than either corn or soy. Sugar cane
uses less fertilizer than corn or soy and produces a higher
yield per hectare, in terms of its energy content. Ethanol is
also produced from what used to be considered a waste
product—the fiber removed from the cane during processing.

If policy makers have their way, however, the situation
may get even worse. Plans in both the United States and EU
call for an increase in the production of biofuels, but neither
political entity has agreed to reduce tariff barriers on sugar
cane, nor remove the trade-distorting subsidies given to
those who produce corn and soy for biofuels. Brazil is not sit-
ting on the sidelines; in 2007 it asked the World Trade Organi-
zation to probe U.S. subsidies to corn farmers for ethanol
production.

Sources: “Cheap No More: Food Prices,” The Economist, December
8, 2007, p. 84; “Brazil Seeks WTO Probe of U.S. Farm Subsidies,”
Journal of Commerce, September 13, 2007, p. 1; M. Wolf, “Biofuels:
An Everyday Story of Special Interests and Subsidies,” Financial
Times, October 31, 2007, p. 11; and J. Von Braun and R. K. Pachauri,
The Promises and Challenges of Biofuels for the Poor in Developing
Countries: IFPRI 2005–2006 Annual Report Essay (Washington, DC:
International Food Policy Research Institute, 2007).

Case Discussion Questions
1. Who benefits from government policies to (a) promote

production of ethanol and (b) place tariff barriers on
imports of sugar cane? Who suffers from these policies?

2. One estimate suggests that if food prices rise by one-
third, they will reduce living standards in rich countries
by about 3 percent, but in very poor ones by about
20 percent. According to the International Food Policy
Research Institute, unless there is a change in policies,
cereal prices will rise by 10 to 20 percent by 2015, and
the expansion of biofuel production could reduce
calorie intake by 2 to 8 percent by 2020 in many of the
world’s poorest nations. Should rich countries do
anything about this? If so, what?

3. The argument for giving subsidies to ethanol producers
rests upon the assumption that ethanol results in lower
CO2 emissions than gasoline and therefore benefits the
environment. If we accept that global warming is a
serious problem, should we not be encouraging
governments to increase such subsidies? What are the
arguments for and against doing so? On balance, what
do you think is the best policy?

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